Question

A firm that is looking to raise capital in the near future. To prepare for potential investors, you determined that you need the WACC of your firm. Your firm is currently structured in such a way that the debt-to-equity ratio is 0.4.

1. Since the company size is comparable with publicly traded micro-cap companies, you started analyzing the Wilshire Micro-Cap ETF, which represents a basket of micro-cap US companies. The current price of this EFT is $29.97. At inception 6.25 years ago it traded at $15.45. In a comparable period, the 3-month T-Bills, which you consider risk free, returned 0.35% annually.

   a.) What was the annualized return for the reference micro-cap ETF?
   b.) During the period considered, what was the risk premium of micro-cap stocks?
   c.) Historically your company has produced equity returns that indicate a beta to the general micro-cap market of around 1.25. Assuming this number will remain stable, what should your cost of equity be?

2. Your only debt outstanding in the market is a single bond with the following parameters:

    10 yrs until maturity
    semiannual coupons with an (annual) coupon rate of 7%
    current market price of 95 (as a percentage of the notional amount)

What is your cost of debt?

3. Given the results from 1 and 2, what is your firm's WACC?

Please provide steps and formulas.

Answer 1

1) Assume corporate tax = 35%

a) Lets assume return on index fund in 6.25 years is Rm

15.45 x (1 + Rm)^6.25 = 29.97

Re = 11.18

b) Risk Premium = Market Return - Risk free rate = 99.012% - 0.35% = 98.662 %

c) Cost of Equity = Risk free + Beta x Market Prmium = 0.35 + 1.25x 98.662 % = 124 %

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2) Lets assume YTM of Bond is i / semiaanual

Number of coupon payment = 10 x2 = 20

Coupon amount = 7% /2 x 1000 = 35

950 = 35 x [1 - (1+i)^-20]] / i + 1000 x (1+i)²⁰

^{By goal seek with xcel, we find i = 3.86%}

^{Cost of Debt is 3.86 %}

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^{3) Debt / Equity = 0.4}

^{Equity Proportion = 71.43% , Debt = 28.57 %}

WACC = Proportion of Debt x cost of Debt x (1-tax) + Proportion of Equity x Cost of Equity

	Prportion	Tax rate	Cost/ Rturn - Yearly	Cost of Debt(After Tax)
Debt	28.57%	35%	3.86%	0.718%
Equity	71.43%	0%	11.18%	7.988%
Total			WACC	8.706%