Question

If Wild Widgets, Inc., were an all-equity company, it would have a beta of 1.55. The company has a target debt–equity ratio of .4. The expected return on the market portfolio is 9 percent, and Treasury bills currently yield 5.4 percent. The company has one bond issue outstanding that matures in 20 years and has a coupon rate of 9.8 percent. The bond currently sells for $1,220. The corporate tax rate is 40 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

Cost of debt

K = N

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

k=1

K =20

1220 =∑ [(9.8*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^20

k=1

YTM = 7.62

B

As per CAPM

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

Cost of equity% = 5.4 + 1.55 * (9 - 5.4)

Cost of equity% = 10.98

C

D/A = 0.4/(1+0.4)

=0.2857

Weight of equity = 1-D/A

Weight of equity = 1-0.2857

W(E)=0.7143

Weight of debt = D/A

Weight of debt = 0.2857

W(D)=0.2857

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

WACC=4.57*0.2857+10.98*0.7143

WACC =9.15%