Question

1. Answer questions 1-4 based on the information provided here: NechMenTin, Inc., has given the following information to you. They want you to calculate their weighted average cost of capital. The company has always followed their ideal capital structure which the management insists is 40% debt and 60% equity capital. The company can issue bonds for 9% coupon rate. The interest is paid semi-annually. The bonds have 22 years to maturity. The bonds can be issued to net the company $835.42. The company’s marginal tax rate is 40%. For cost of equity, the company uses the CAPM based on SML. The risk free rate in the market is 8% and the market rate of return is 14%. The company has a beta of 1.1. Based on the information provided above, what is NechMenTin’s before tax cost of debt? (Points : 3)        11%        12%        10%        8%

Question 2.2. What is NechMenTin’s after-tax cost of debt? (Points : 3)        6.6%        7.2%        6%        4.8%

Question 3.3. What is the NechMenTin company’s cost of equity capital using the CAPM? (Points : 3)        9.6%        8%        14.6%        12.99%

Question 4.4. A. Roul, a new investment banker contends that the company’s cost of capital is 8.6%. Based on the answers from the three questions above, what is the actual weighted average cost of capital for NechMenTin, Inc? (Points : 3)        10.02%        11.40        12.86%        14%

Answer 1

1) Taking $1000 par value, we have -

Semi - annual interest payment = $1000 x 9% x 6 / 12 = $45

Total semi - annual periods till maturity = 22 x 2 = 44

First, compute approximate YTM using the following formula -

where, I = interest payment, RV = redeemable value, MV = market value, n = no. of time periods

or, Approx YTM = 5.31%

Now, YTM is close to this rate. We need to choose two rates close to approximate YTM and compute the market value of the bond at those rates. The rate at which market value is equal to the offered value will be the YTM. Remember, the closer the rates to YTM, the closer will be your answer.

Lets take 5.30% and 5.5%.

At 5.30%, Bond price = $45 x PVIFA (5.30%, 44) + $1000 x PVIF (5.30%, 44) = $45 x 16.9231207111 + $1000 x 0.10307460222 = $864.615034219

At 5.50%, Bond price = $45 x PVIFA (5.50%, 44) + $1000 x PVIF (5.50%, 44) = $45 x 16.4578506329 + $1000 x 0.09481821508 = $835.42149356 or $835.42

As we can see that at 5.50%, price is equal to the current market price. Therefore, our YTM is 5.50%. But, this is the semi - annual rate, so, annual YTM = 5.50% x 2 = 11%

Before tax cost of debt = 11%

Note :

PVIF = 1 / (1 + r)n

2) After tax cost of debt = before tax cost of debt x (1 - tax rate) = 11% x (1 - 0.40) = 6.6%

3) Cost of equity using CAPM is computed as follows -

Cost of equity = risk free rate + beta x (Market rate of return - risk free rate) = 8% + 1.1 x (14% - 8%) = 14.6%

4) WACC = After tax cost of debt x weight of debt + Cost of equity x weight of equity

or, WACC = 6.6% x 0.40 + 14.6% x 0.60 = 11.40%