Question

Hilton Corporation has 1 million shares of common stock outstanding and 80,000 bonds with 6% coupon at $1000 par each. The stock currently sells at $53 per share and has a beta of 1.15; the bonds have 25 years to maturity and sell at $1141. The market risk premium is 6.8% and Treasury bills are yielding 3.1%. If Hilton’s corporate tax rate is 21%, what is the company’s cost of capital (WACC)?

Answer 1

To find the wacc, we need to understand the weight of debt, equity and the cost of each of these types of financing.

Wacc = Cost of equity * Weight of equity + After tax cost of Debt * Weight of debt

Cost of equity:

Using CAPM model, Cost of equity = Risk free rate + Beta * Market risk premium

Risk free rate = T bill rate = 3.1%

Market risk premium = 6.8%

Beta = 1.15

Cost of equity = 3.1% + 1.15 * 6.8% = 10.92%

Total debt = 80000*1000 = 80000000

Total equity = 53*1000000 = 53000000

Weight of equity = (Price of share * No of shares outstanding)/(Debt + equity) = 53000000/(80000000+53000000)= 53000000/133000000 = 39.8 %

Weight of debt =(Face value of bonds * Number of bonds)/(Debt + equity) = 80000000/133000000 = 60.2 %

Cost of debt :

We need to find the yield to maturity for the bonds to find the cost of debt.

Using YTM formula :( (C+F - P)/n)/((F+P)/2)

Face value = F= 1000, Price = P = 1141, Annual coupon= 6% so C = 60, Tenure = n = 25 years

The YTM is 5.005%. Hence after tax cost of debt = YTM ( 1-tax rate) = 5.005*(1-0.21) = 3.95%

Wacc = 10.92% * 39.8% + 3.95% * 60.2% = 6.72%