Question

The Fresno Eastern Company (FEC) bond carries a coupon rate of 6% with semi-annual payments, a $1,000 par, and a maturity of 20 years. The current price of the bonds is $990. The firm’s average tax rate is 21%. What is its after-tax cost of bonds (debts)? Round the answers to 4 decimal places, e.g., 0.3216.

Treasury bond currently yields 1.80% and the expected market return is 8%. FEC’s beta is 0.98. Please use the CAPM model to calculate FEC’s cost of common stock?

FEC’ capital structure is as follows:
Bonds (2,000 bonds outstanding) $1,960,000
Common stock (600,000 shares) $6,000,000
Based on your calculation on its cost of debts and common stocks, what is FEC’s WACC (weighted average cost of capital)?

Answer 1

1. Use RATE function in EXCEL to find the cost of debt

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

nper=20*2=40

pmt=semi-annual coupon=(coupon rate*face value)/2=(6%*1000)/2=60/2=30

pv=990

fv=1000

=RATE(40,30,-990,1000,0)=3.044%

Cost of debt=2*3.044%=6.09%

After tax cost of debt=cost of debt*(1-tax rate)=6.09%*(1-21%)=4.81%

2. cost of common stock=risk free rate+(beta*(market return-risk free rate))=1.8%+(0.98*(8%-1.8%))=7.88%

3. WACC=(weight of debt*after tax cost of debt)+(weight of common stock*cost of common stock)

weight of debt=value of debt/Total value=1960000/7960000=24.62%

weight of common stock=6000000/7960000=75.38%

WACC=(24.62%*4.81%)+(75.38%*7.88%)=7.12%