Question

1. Use the data from the table below to estimate the weighted average cost of capital for ABC, Inc.   Show and label your work. Justify and explain each of your estimates.

Current T-Bill Yield	1.06%
Current 30 Year Treasury Yield	2.75%
1926-2011 Arithmetic Average T-Bill Return	3.62%
1926-2011 Arithmetic Average 30 Year Treasury Return	6.14%
1926-2011 Geometric Average T-Bill Return	3.58%
1926-2011 Geometric Average 30 Year Treasury Return	5.72%
1926-2011 Arithmetic Average of S&P500 less T-Bill Return	8.14%
1926-2011 Geometric Average of S&P500 less T-Bond Return	4.27%
Current before-tax Cost of Debt	6.00%
Market Value of Debt (in millions)	$475
Book Value of Debt (in millions)	$500
Book Value of Equity (in millions)	$580
Current Stock Price	$63
Shares of Common Outstanding (in millions)	10
Marginal corporate Tax Rate	35%
Levered Beta	1.70
Unlevered Beta	0.95

Answer 1

WACC = Cost of Equity * Weightage of Equity in total Capital + Cost of Debt * Weightage of Dabt in total capital

Calculation of each component shown below -

(1)

Cost of Equity = Rf + (Equity Risk Premimum) * Unlevered Beta

Consider current T-bill yield as the risk free rate since it is as good as having zero risk of default being government backed.

Hence,Rf =1.06%

Consider 1926-2011 Arithmetic Average of S&P500 less T-Bill Return as the Equity risk premium since it is the average return that the broader equity market has over the risk free rate.

Hence, ERP = 8.14%

For Beta, take unlevered beta since it is the one which excludes any debt and we need only the cost of quity.

So,

Cost of Equity = 1.06% + 8.14% * 0.95 = 8.79%

(2)

Cost of Debt = 6% * (1 -Tax rate) = 6% * (1- 0.35) = 3.9%

It is provided in the question that before tax cost of debt if 6%

(3)

Total MV of firm = MV of Equity + MV of Debt

= Stock price * Current Oustanding number of shares + 475 millions

= 10 * 63 millions + 475 millions

=1105 millions

Weightage of Equity = (10*63)/1105 = 0.57

Weightage of Debt = 475/1105 = 0.43

Therefore, applying into the very first formula

WACC = Cost of Equity * Weightage of Equity in total Capital + Cost of Debt * Weightage of Dabt in total capital

WACC = 8.79% * 0.57 + 3.9% * 0.43 = 5.01%