Question

Problem 10

A firm has market value of equity of $10M and market value of debt of $10M. Yield to maturity of its debt is 10%, while the expected return of its stock is 20%. Assume that the tax rate is 0%. The WACC is given by:

A) 8%

B) 12%

C) 15%

D) 18%

E) 21%

Answer 1

Solution for Problem 10

Given data in the problem are

a) Market value of Equity = $ 10 M

b) Market Value of Debt = $ 10 M

Therefore, Weight of Equity = Market value of Equity / (Market value of Equity + Market value of Debt )

= 10 / (10 + 10 )  

= 10 / 20

Weight of Equity = 0.5  

Weight of Debt    = Market value of Debt / (Market value of Equity + Market value of Debt)

= 10 / (10 + 10 )  

   = 10 / 20

Weight of Debt     = 0.5

c) Yield to Maturity of Debt = Cost of Debt = 10%

d) Expected return of Stock = Cost of Equity = 20%

e) Tax rate, T = 0%

Now to Compute WACC (Weighted average cost of capital) we use the below formula

WACC = [ Cost of Equity * Weight of Equity ] + [ Cost of Debt * ( 1 - Tax rate ) * Weight of Debt ]

Plugging in the above given values, we get

WACC = [ 20% * 0.5 ] + [ 10% * (1 - 0%) * 0.5 ]

= [20% * 0.5] + [ 10% * 1 * 0.5 ]

= [20% * 0.5] + [ 10% * 0.5 ]

= [20% * 0.5] + [ 5% ]

= [10% ] + [ 5% ]

WACC = 15%

Answer: WACC is Choice C i.e. 15%