Question

A Company’s balance sheet shows a total of $30 million long term debt with coupon rate of 8%. The yield to maturity on this debt is 10%, and the debt has a total market value of $38 million. The company has 10 million shares of stock, and the stock as a book value per share of $7. The current stock price is $25 per share and the stockholders required rate of return rs is 13%. The company recently decided that its target capital structure should have 35% debt, with the balance being equity. The tax rate is 35%. Calculate WACCs based on book, market and target capital structures. What is the sum of three WACCs? (Book equity = BV/share * No. Shares, Market equity = P0 * No. Shares). Kindly show working on every step?

Answer 1

Answer : Calculation of Sum of three WACCs

Calculation of WACC based on Target Capital Structure :

WACC = (Cost of Before tax Debt * (1 - tax rate) * Weight of Debt) + ( Cost of Equity * Weight of Equity)

= (10% * (1 - 0.35) * 0.35) + (13% * 0.65)

= 2.275% + 8.45%

= 10.725%

Calculation of WACC based on Book Value Weights :

WACC = (Cost of Before tax Debt * (1 - tax rate) * Weight of Debt) + ( Cost of Equity * Weight of Equity)

= (10% * (1 - 0.35) * 0.30) + (13% * 0.70)

= 1.95% + 9.1%

= 11.05%

Working Note :

Book Value of Debt = 30 million

Book Value of Equity = BV/share * No. Shares = 7 * 10million = 70 million

Total Book Value = Book Value of Debt + Book Value of Equity = 30 million + 70 million = 100 million

Weight of Debt = Book Value of Debt / Total Book Value = 30 / 100 = 0.30

Weight of Equity = Book Value of Equity / Total Book Value = 70 / 100 = 0.70

Calculation of WACC based on Market Value Weights :

WACC = (Cost of Before tax Debt * (1 - tax rate) * Weight of Debt) + ( Cost of Equity * Weight of Equity)

= (10% * (1 - 0.35) * 0.13194444) + (13% * 0.868056)

= 0.8576388886% + 11.28%

= 12.14%

Working Note :

Market Value of Debt = 38 million

Market Value of Equity = MV/share * No. Shares = 25 * 10million = 250 million

Total Market Value = Market Value of Debt + Market Value of Equity = 38 million + 250 million = 288 million

Weight of Debt = Market Value of Debt / Total Market Value = 38 / 238 = 0.1319444

Weight of Equity = Market Value of Equity / Total Book Value = 250 / 288 = 0.868056

Total Sum of WACC = 10.725% + 11.05% + 12.14% = 34.92%