Question

​(Weighted average cost of​ capital) Bane Industries has a capital structure consisting of 61 percent common stock and 39 percent debt. The​ firm's investment banker has advised the firm that debt issued with a ​$1 comma 000 par​ value, 7.5 percent coupon​ (interest paid​ semiannually), and maturing in 20 years can be sold today in the bond market for ​$1 comma 120. Common stock of the firm is currently selling for ​$80.08 per share. The firm expects to pay a ​$2.09 dividend next year. Dividends have grown at the rate of 7.9 percent per year and are expected to continue to do so for the foreseeable future. What is ​ Bane's average cost of capital where the firm faces a tax rate of 34 ​percent?

a.  The​ after-tax cost of debt is

____​%. ​(Round to two decimal​ places.)

b. The cost of common equity is

____​%. ​(Round to two decimal​ places.)

c.  Bane's average cost of capital is

____​%. ​(Round to two decimal​ places.)

Answer 1

a). Face/Par Value of Bond = $1000

Semi-annual Coupon rate = 7.5%

Semi-annual Coupon payment = $1000*7.5%*1/2 = $37.5

Price of bond = $ 1,120

Maturity(n) = 20 years*2 = 40

Calculating YTM of the bond:

Taking YTM as 6%

Semi-annual Ytm = 6%/2 = 3%

Price = $ 866.81 + $ 306.56

Price = $ 1173.37

Now, Since, At YTM 6% price is closer to Original price, taking another YTM at 7%

Semi-annual YTM = 7%/2 = 3.5%

Price = $ 800.82 + $ 252.57

Price = $ 1053.39

Now, calculating YTM:

YTM = 6.44%

Tax Rate = 34%

After tax cost of debt = Cost of debt(1-Tax rate)

= 6.44%(1-0.34)

= 4.25%

So,  The​ after-tax cost of debt is 4.25%

b). Price of Stock(P0) = $ 80.08

Expected Dividend next year (D1) = $2.09

Growth rate of dividend(g) = 7.9%

Calculating the cost of Equity:

Ke = (D1/P0) +g

Ke = (2.09/80.08) + 0.079

ke = 10.51%

So, The cost of common equity is 10.51%

c). Weights of Common Stock is 61% while of debt is 39%

- Calculating WACC based on Weights and cost of funds:

WACC= (Weight of Debt)(After tax Cost of Debt) + (Weight of Common stock)(Cost of Equity)

WACC = (0.39)(4.25%) + (0.61)(10.51%)

WACC = 8.07%

So, Bane's Average Cost of capital is 8.07%