Question

If Wild Widgets, Inc., were an all-equity company, it would have a beta of 1.1. The company has a target debt–equity ratio of .5. The expected return on the market portfolio is 13 percent, and Treasury bills currently yield 3.5 percent. The company has one bond issue outstanding that matures in 20 years and has a coupon rate of 8 percent. The bond currently sells for $1,130. The corporate tax rate is 34 percent.

  

a.	What is the company’s cost of debt? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

  

Cost of debt

%

  

b.	What is the company’s cost of equity? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

  

Cost of equity

%

  

c.	What is the company’s weighted average cost of capital? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

  

WACC

%

Answer 1

a

Note: I have calculated using annual compounding as it is not given in the question that is semi annual. If incorrect let me know I will calculate with semi annual compounding

Cost of debt

K = N

Bond Price =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =20

1130 =∑ [(8*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^20

k=1

YTM = 6.79

b

As per CAPM

Cost of equity = risk-free rate + beta * (expected return on the market - risk-free rate)

Cost of equity% = 3.5 + 1.1 * (13 - 3.5)

Cost of equity% = 13.95

c

D/A = D/(E+D)

D/A = 0.5/(1+0.5)

=0.3333

Weight of equity = 1-D/A

Weight of equity = 1-0.3333

W(E)=0.6667

Weight of debt = D/A

Weight of debt = 0.3333

W(D)=0.3333

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=4.48*0.3333+13.95*0.6667

WACC =10.79%