Question

yield-to-maturity on long-term government bonds 3.4%.

Yield-to maturity on TM Industry's long-term bonds 8.1%.

Market risk premium 6%

estimated company equity beta 1.4

stock prince per share $30.00

number of share outstanding 60 million

TM industries debt value $1.2 million

tax rate 25%

1. It's WACC is:

a. 6.46%

b. 9.51%

c. 8.35%

d. 10.16%

Answer 1

WACC stands for Weighted Average Cost of Capital. Company runs it’s business by issuing equities and / or by issuing interest paying bonds. WACC is the cost of companies various capital sources.

Formula of WACC:

WACC = (MVE/TV*Ke)+(MVD/TV*Kd)*(1-tax)

Where,

MVE = Market value of company’s equity.

MVD -= Market value of company’s debt

TV = MVE + MVD

Ke = Cost of equity

Kd = Cost of debt

Let’s calculate cost of equity: Risk free rate + Beta * (Market returns – Risk free rate)

Let’s consider

• Risk free rate as Yield-to-maturity on long-term government bonds 3.4%.
• Market risk premium 6% as market returns
• Beta as estimated company equity beta 1.4

Input these figures in Cost of equity formula: Risk free rate + Beta * (Market returns – Risk free rate)

= 3.4% + 1.4 * (6%-3.4%)

= 7.04% is Cost of equity i.e. Ke

Let us calculate Total Value i.e. TV now,

Stock Price per share $30.00* number of share outstanding 60 million = Equity = 1800 Million is market value of equity.

TM industries debt value $1.2 million

Total value (TV) of Capital = Equity + debt = 1800+1.2 = 1801.2 Million

Equity linked cost = (MVE/TV*Ke) = (1800/1801.2)*7.04% = 7.03%

Now let us calculate debt part of WACC i.e. (MVD/TV*Kd)*(1-tax)

First calculate cost of debt i.e. Kd = Yield-to maturity on TM Industry's long-term bonds 8.1%. (Given)

Market value of debt i.e. MVD = TM industries debt value $1.2 million

Total Value = TV = 1801.2 Million

(1-tax) = (1-25%) = 75%

(MVD/TV*Kd)*(1-tax) = (1.2million / 1801.2 million)*8.1%*75% = 0.40% is debt linked cost of capital

By combining Equity linked cost of capital and debt linked cost of capital we get Weighted Average Cost of Capital.