Question

To estimate the company's WACC, Marshall Inc. recently hired you as a consultant. You have obtained the following information. (1) The firm's noncallable bonds mature in 20 years, have an 9.00% annual coupon, a par value of $1,000, and a market price of $950.00. (2) The company's tax rate is 30%. (3) The risk-free rate is 2.50%, the market risk premium is 4.50%, and the stock's beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new shares. What is its WACC?

Coupon rate

Maturity

Bond price

Par value

Tax rate

Risk-free rate

Market risk premium

Marshall's beta

Target debt weight

Target equity weight

Before tax cost of debt

After tax cost of debt

Cost of equity

WACC

Answer 1

WACC = Weight of equity * Cost of equity + Weight of debt * After tax Cost of debt

Weight of debt = 35%

Weight of equity = 100% - 35% = 65%

Cost of equity using CAPM Equation:

Risk free rate + Beta * Market risk premium = 2.50% + 1.20 * 4.50% = 7.9%

Cost of debt = Yield on the bonds

Using the RATE function in excel we can calculate the yield.

NPER = Number of periods = 20, PMT = Periodic payment = 1000*9% = 90, Present value or PV = 950, Future value or face value = 1000.

The yield is 9.57% and this is the before tax cost of debt.

After tax cost of debt = Before tax cost of debt * (1 - Tax rate) = 9.57% * (1 - 30%) = 6.70%

WACC = Weight of equity * Cost of equity + Weight of debt * After tax Cost of debt

= 65% *  7.9% + 35% * 6.70% = 7.48%