Question

ABC Inc. recently is doing the following financing: (1) The firm's non-callable bonds mature in 20 years, have an 6.00% annual coupon, a par value of $1,000, and a market price of $1,050.00. (2) The company’s tax rate is 40%. (3) The risk-free rate is 5%, the market return is 12%, and the stock’s beta is 1.20. (4) The target capital structure consists of half debt and half 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? (12’)

Answer 1

Solution:-

a) Calculation of cost of debt (i.e. YTM of bond)

Par value of bond= $1000

Coupon rate = 6%

Current market price of bond= $1050

Annual interest = $1000*6%= $60

life of bond = 20 years

We will use hit and trail method to calculate the YTM of the bond .

Since the bond is trading at premium , hence YTM of the bond should be less than coupon rate of bond(ie6%.)

i) Let us evaluate the PV of bond at 5% discount rate (DR)

PV of inflow

= Annual interest *PVIFA(DR, life)+Maturity value*PVIF(DR, life)

Now substituting values

=60*PVIFA(5%,20)+1000*PVIF(5%,20)

=60*12.46221+1000*0.376889

=747.7326+376.889

=$1124.62

ii) At 6% discount rate the price of bond will be $1000.

Now YTM of bond can be calculated as follows

YTM=Lower DR+Difference b/w DRs{[PV of lower DR-PV]/Absolute difference B/w DRs}

Where, DR stands for discount rate

            PV stands for present value

            B/W stands for between.

Now substituting the value

YTM =5%+1%[1124.62-1050]/[1124.62-1000]

          =5%+1%*74.62/124.62

          =5%+0.5987%

          =5.5987%

Hence the before tax cost of debt = 5.60%

b) Now calculating cost of equity

Using CAPM model

Required rate of return = Rf+Beta*(Rm-Rf)

Where

Rf= Risk free return = 5%

Rm= market return = 12%

beta= 1.20

Substituting the values:-

RR= 5%+1.20*(12%-5%)

          =13.4%

Hence the cost of equity = 13.40%

Calculation of WACC

WACC= Kd(1-tax)*Wd+Ke*We

Where

Kd= cost of debt = 5.60%

Ke= Cost of equity = 13.40%

Wd= weights of debt to total capital = 0.50

We= Weight of equity to total capital= 0.50

Substituting values :-

WACC= 5.60%*(1-0.40)*0.50+13.40%*0.50

             =1.68%+6.7%

             =8.38%

Please feel free to ask if you have any query in the comment section.