Question

• A corporation has 10,000 bonds outstanding with a 6% annual coupon rate, 8 years to maturity, a $1,000 face value, and a $1,100 market price.
• The company’s 500,000 shares of common stock sell for $25 per share and have a beta of 1.5. The risk free rate is 4%, and the expected return on the market is 12%.
• The company recently paid a dividend of $2.0 per share on the common stock. The expected dividend growth rate is 7%.
• The company takes the average of cost of equity calculations from DGM and CAPM models to determine cost of equity for WACC.
• Assuming a 40% tax rate, what is the company’s WACC?

Answer 1

As per CAPM

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

Expected return% = 4 + 1.5 * (12 - 4)

Expected return% = 16

MV of equity=Price of equity*number of shares outstanding

MV of equity=25*500000

=12500000

MV of Bond=Par value*bonds outstanding*%age of par

MV of Bond=1000*10000*1.1

=11000000

MV of firm = MV of Equity + MV of Bond

=12500000+11000000

=23500000

Weight of equity = MV of Equity/MV of firm

Weight of equity = 12500000/23500000

W(E)=0.5319

Weight of debt = MV of Bond/MV of firm

Weight of debt = 11000000/23500000

W(D)=0.4681

Cost of debt

K = Nx2

Bond Price =∑ [(Semi Annual Coupon)/(1 + YTM/2)^k]     +   Par value/(1 + YTM/2)^Nx2

k=1

K =8x2

1100 =∑ [(6*1000/200)/(1 + YTM/200)^k]     +   1000/(1 + YTM/200)^8x2

k=1

YTM = 4.4977973075

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 4.4977973075*(1-0.4)

= 2.6986783845

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

WACC=2.7*0.4681+15.78*0.5319

WACC =9.66%

Price = recent dividend* (1 + growth rate )/(cost of equity - growth rate)

25 = 2 * (1+0.07) / (Cost of equity - 0.07)

Cost of equity% = 15.56

Cost of equity = average of the two = (16+15.56)/2 = 15.78