ABC Inc. recently is doing the following financing: (1) The firm's non-callable bonds mature in 30...

ABC Inc. recently is doing the following financing: (1) The firm's non-callable bonds mature in 30 years, have an 6% Yield to Maturity. (2) The company’s tax rate is 30%. (3) The risk-free rate is 3%, the market return is 15%, and the stock’s beta is 1.10. (4) (4) The target capital structure has a debt to equity ratio of 1.75. The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new shares. What is its WACC? Please show work & formula. Excel

Solutions

Expert Solution

After-tax cost of debt

The after-tax cost of debt on the Bond is the after-tax Yield to maturity (YTM)

The After-tax cost of debt = Annual Yield to maturity on the bond x (1 – Tax Rate)

= 6.00% x (1 – 0.30)

= 6.00% x 0.70

= 4.20%

Cost of Equity

As per Capital Asset Pricing Model [CAPM], the cost of equity is calculated by using the following equation

Cost of equity = Risk-free Rate + Beta(Market rate – Risk free rate)

= 3.00% + 1.10(15.00% - 3.00%)

= 3.00% + [1.10 x 12.00%]

= 3.00% + 13.20%

= 16.20%

Company’s Weighted Average Cost of Capital (WACC)

Therefore, the Weighted Average Cost of Capital (WACC) = [After-tax cost debt x Weight of Debt] + [Cost of Equity x Weight of Equity]

= [4.20% x (1.75 / 2.75)] + [16.20% x (1 / 2.75)]

= [4.20% x 0.63636] + [16.20% x 0.36364]

= 2.67% + 5.89%

= 8.56%

Hence, the Weighted average cost of capital (WACC) will be 8.56%

NOTE

Weight of Debt = Debt-to-equity ratio / (1 + Debt-to-equity ratio)

Weight of Equity = 1 / (1 + Debt-to-equity ratio)

jeff jeffy answered 1 year ago

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