Question

The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.

Assets
Current assets	$ 38,000,000
Net plant, property, and equipment	101,000,000
Total assets	$139,000,000
Liabilities and Equity
Accounts payable	$ 10,000,000
Accruals	9,000,000
Current liabilities	$ 19,000,000
Long-term debt (40,000 bonds, $1,000 par value)	40,000,000
Total liabilities	$ 59,000,000
Common stock (10,000,000 shares)	30,000,000
Retained earnings	50,000,000
Total shareholders' equity	80,000,000
Total liabilities and shareholders' equity	$139,000,000

The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.

1. What is the best estimate of the after-tax cost of debt?

2. Based on the CAPM, what is the firm's cost of common stock?  

3. Which of the following is the best estimate for the weight of debt for use in calculating the firm's WACC?

4. What is the best estimate of the firm's WACC?

Answer 1

1

Cost of debt

K = Nx2

Bond Price =∑ [(Semi Annual Coupon)/(1 + YTM/2)^k]     +   Par value/(1 + YTM/2)^Nx2

k=1

K =20x2

875 =∑ [(7.25*1000/200)/(1 + YTM/200)^k]     +   1000/(1 + YTM/200)^20x2

k=1

YTM = 8.5668506017

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 8.5668506017*(1-0.4)

= 5.14

2

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (expected return on the market - risk-free rate)

Cost of equity% = 5.5 + 1.25 * (14.5 - 5.5)

Cost of equity% = 16.75

3

MV of equity=Price of equity*number of shares outstanding

MV of equity=15.25*10000000

=152500000

MV of Bond=Par value*bonds outstanding*%age of par

MV of Bond=1000*40000*0.875

=35000000

MV of firm = MV of Equity + MV of Bond

=152500000+35000000

=187500000

Weight of debt = MV of Bond/MV of firm

Weight of debt = 35000000/187500000

W(D)=0.1867

4

Weight of equity = MV of Equity/MV of firm

Weight of equity = 152500000/187500000

W(E)=0.8133

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=5.14*0.1867+16.75*0.8133

WACC =14.58%