Question

A firm has determined its cost of each source of capital and optimal capital structure, which is composed of the following sources and target market value proportions. To get the cost of equity, the following is provided, Risk free rate of return is 5%, the stock has a Beta of 1.25x and the Market Return is expected to be 11.5%. The firms existing debt has a 8.5% coupon 9 year maturity and trades at 93.75%. The firm is in the 40% tax bracket.

Source of capital / Target Market Proportions / Pre-Tax Cost

Long Term Debt / 40% / ?

Preferred Stock / 10% / 11%

Common Stock Equity / 50% / ?

The weighted average cost of capital is?

Answer 1

Cost of equity = risk free rate+ Beta*(market return-risk-free rate)

= 5%+ 1.25*(11.5%-5%)

=13.125%

Cost of long-term debt=YTM of the debt*(1-tax rate)

Using financial calculator

Input:Fv = 1000

PV = 93.75%*1000 = 937.5

PMT = 8.5%*1000 = 85

N = 9

Solve for I/Y as 9.57%

This is the pre-tax cost

WACC = 40%*9.57%*(1-0.4) + 10%*11%+ 50%*13.125%

=9.96%