Question

Consider the following information concerning Pacific Stars lnc.'s capital structure:

1. The company has 80,000 shares of common stock outstanding at a current market price of $20 per share. The stock has a beta of 1.2. The market risk premium is 6% and the risk-free rate is 3%
2. The company has 2000 bonds outstanding, with 6% coupon and 20 years to maturity. The bond is currently selling for $1,103.8, with a yield-to-maturity of 5%
3. The tax rate for the company is 20%

A) What is the cost of equity for Pacific Stars?
B) What is the weighted average cost of capital for Pacific Stars?

Please show your work

Answer 1

A) cost of equity for Pacific Stars = risk-free rate + beta of stock*market risk premium

cost of equity for Pacific Stars = 3% + 1.2*6% = 3% + 7.2‬% = 10.2‬%

the cost of equity for Pacific Stars is 10.2%.

B) weighted average cost of capital for Pacific Stars = weight of debt*after-tax cost of debt + weight of equity*cost of equity

weight of debt = market value of debt/(market value of debt + market value of equity)

weight of equity = market value of equity/(market value of debt + market value of equity)

market value of debt = no. of bonds outstanding*current selling price of bonds = 2,000*$1,103.8 = $2,207,600‬

market value of equity = no. of shares outstanding*current market price per share = 80,000*$20 = $1,600,000‬

weight of debt = $2,207,600($2,207,600 + $1,600,000‬) = $2,207,600‬/$3,807,600‬ = 0.58

weight of equity = $1,600,000‬($2,207,600 + $1,600,000‬) = $1,600,000‬‬/$3,807,600‬ = 0.42

cost of debt is the yield to maturity of the bond which is the return bondholder will earn if he holds the bond till maturity.

after-tax cost of debt = cost of debt*(1-tax rate) = 5%*(1-0.20) = 5%*0.80 = 4%

cost of equity is 10.2% calculated in part A).

weighted average cost of capital = 0.58*4% + 0.42*10.2% = 2.32‬% + 4.28% = 6.60%

the weighted average cost of capital for Pacific Stars is 6.60%.