Question

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Consider the following information concerning Pacific Stars lnc.'s capital structure: 1. The company has 80,000 shares...

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

Expert Solution

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%.

jeff jeffy answered 1 year ago

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