Question

Assume that you have been hired as a consultant by Clabber Girl, a major producer of home kitchen goods, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.

Liabilities and Equity (Reduced for simplicity; shows book-values only)

Long-term debt (40,000 bonds, $1,000 par value)	$40,000,000
Common stock (10,000,000 shares)	$30,000,000

The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 1.70% bonds with semiannual payments that are currently selling for $3,680. The beta is 1.1, the risk free rate is 3.5%. The market has had an average annual return of 14.50% during the past 5 years, and the firm's tax rate is 30%. The firm has no preferred stock.

What is the best estimate of the firm's WACC using market weights?

Answer 1

WACC=(weight of equity*cost of equity)+(weight of debt*after tax cost of debt)

Market value of equity=number of sahres*price=10,000,000*15.25=152,500,000

Market value of debt=number of bonds*price=40,000*3680=147,200,000

Weight of equity=152,500,000/(152,500,000+147,200,000)=50.88%

Weight of debt=1-50.88%=49.12%

==>Use RATE function in EXCEL to find the cost of debt

=RATE(nper,pmt,pv,fv,type)

nper=20 years*2=40

pmt=semi-annual coupon=(coupon rate*face value)/2=(1.7%*1000)/2=17/2=8.5

pv=3680 (Please check as this value looks vey high. It can affect the answer as a whole)

fv=1000

=RATE(40,8.5,-3680,1000,0)=-2.75%

After tax cost of debt=cost of debt*(1-tax rate)=-2.75%*(1-40%)=-1.65%

Cost of equity=risk free rate+(beta*(market return-risk free rate))=3.5%+(1.1*(14.5%-3.5%))=15.6%

WACC=(50.88%*15.6%)+(49.12%*-1.65%)=7.13%