Question

3. What is the weighted average cost of capital (WACC) and provide the equation when long-term debt and common equity are used to obtain capital funds? Please describe each component and how you measure each? How does a higher beta affect WACC and why? How does a drop in the bond market effect WACC and why? What is the WACC for a public utility given the following information: beta: 0.8, expected rate of return on the S&P 500: 12.4%, risk-free rate (T-bill yield): 4%, yield to maturity on long-term bonds: 7.2%, required rate of return on preferred stock: 7.5%, common equity ratio: 60%, debt ratio: 30%, preferred stock ratio: 10% and an effective corporate tax rate: 30%.

Answer 1

Weight of Capital Structure

Weight of Debt = 30%

Weight of Preferred stock = 10%

Weight of Equity = 60%

After-tax cost of debt

The firm’s after-tax cost of debt on the Bond is the after-tax Yield to maturity (YTM)

The After-tax cost of debt = Yield to maturity on the bond x (1 – Tax Rate)

= 7.20% x (1 – 0.30)

= 7.20% x 0.70

= 5.04%

Cost of Preferred Stock = 7.50%

Cost of Equity

As per Capital Asset Pricing Model [CAPM], the Cost of Equity is calculated by using the following equation

Cost of Equity = Risk-free Rate + Beta(Market Rate of Return – Risk-free Rate)

= Rf + B[Rm – Rf]

= 4.00% + 0.80[12.40% - 4.00%]

= 4.00% + [0.80 x 8.40%]

= 4.00% + 6.72%

= 10.72%

Weighted Average Cost of Capital (WACC)

Therefore, the Weighted Average Cost of Capital (WACC) [After Tax Cost of Debt x Weight of Debt] + [Cost of Preferred stock x Weight of preferred stock] + [Cost of equity x Weight of Equity]

= [5.04% x 0.30] + [7.50% x 0.10] + [10.72% x 0.60]

= 1.51% + 0.75% + 6.43%

= 8.69%

“Hence, the Weighted Average Cost of Capital (WACC) will be 8.69%”