Question

AFKAP Industries has 2 million shares of stock outstanding selling at $13 per share, and an issue of $12 million in 8.5 percent annual coupon bonds with a maturity of 20 years, selling at 107 percent of par. Assume TAFKAP’s weighted average tax rate is 34 percent and its cost of equity is 13.0 percent. What is TAFKAP’s WACC?

Answer 1

In this case, we need to find the market interest rate i.e. yield to maturity

Yield to maturity would be the rate which will make present value of bond equal to its market price

Price of a bond is present value of all its remaining payments i.e. all remaining coupon payments and maturity payment

Present value of a payment = Cash flow/(1+r)ⁿ

where r is rate of interest and n is period of cash flow

Price of a bond = C/(1+r)¹ + C/(1+r)² + ..................... + C/(1+r)ⁿ + M/(1+r)ⁿ

where C is coupon payment, r is yield to maturity, and M is value at maturity

At maturity the bond will pay the issued amount i.e. $12 million

Coupon amount = 0.085*12 = $1.02 million

n = 20 years

Bond is selling at 107% of par

Therefore current market value = 107/100 * 12 = $12.84 million

Now putting all this in bond equation

12.84 = 1.02/(1+r)¹ + 1.02/(1+r)² + ...................... + 1.02/(1+r)¹⁹ + (1.02+12)/(1+r)²⁰

Solving this we get r as 7.798%

So the market interest rate = 7.798%

WACC = w_e*r_e + w_d*r_d*(1-t), where w_e is weight of equity, r_e is cost of equity, w_d is weight of debt, r_d is cost of debt and t is tax rate

w_e = Market value of equity/(Market value of equity + market value of debt)

w_d = Market value of debt/(Market value of equity + market value of debt

Market value of equity = Share price*Number of outstanding shares = 13*2 = $26 million

Market value of debt = $12 million

Cost of equity = 13%

tax rate = 34%

w_e = 26/(26+12) = 0.68

w_d = 12/(26+12) = 0.32

Purring all these value in WACC equation

WACC = (13* 0.68) + (7.798*0.32*(1-0.34)) = 10.52%

WACC of TAFKAP's = 10.52%