Question

1. Weighted average cost of capital Suppose Enviro-tech is attempting to estimate its cost of capital (WACC). The company has 1,500,000 shares of stock outstanding that currently sells for $50 per share. In addition, the company has 25,000 bonds outstanding with 10 years left until maturity that pay a $1,000 par value and an annual coupon of 5.0%. Management believes these bonds would sell for 1,010.50 in today’s market. The company’s beta is 1.1, the risk-free rate is 2% and the market risk premium is 8%. The tax rate is 25%.

a. What is the total market value of the company's stock (MVE)

b. What is the total market value of the company's bonds (MVD)?

c. What is the total market value of the firm's financial contacts (total invested capital)?

d. Estimate the percentage of the company financed with debt (w_d

e. Estimate the percentage of the company financed with equity (w_s)

f. Estimate the firm's cost of debt (r_d)

g. Estimate the firm's cost of equity (r_s) using the CAPM.

h. Compute an estimate of the firm's weighted average cost of capital (WACC)

Answer 1

a.Total market value of company's stock= 1,500,000*$50= $75,000,000.

b.Total market value of company's bonds= 25,000*$1,010.50= $25,262,500.

c.Total market value of company's financial contacts= $75,000,000 + $25,262,500

= $100,262,500.

d.Percentage of company financed with debt= $25,262,500/ $100,262,500

= 0.2520*100

= 25.20%.

e..Percentage of company financed with equity= $75,000,000/ $100,262,500

= 0.7480*100

= 74.80%

f.Information provided:

Par value= future value= $1,000

Current price= present value= $1,010.50

Coupon rate= 5%

Coupon payment= 0.05*$1,000= $50

Time= 10 years

The cost of debt is calculated by computing the yield to maturity.

The yield to maturity is computed by entering the below in a financial calculator:

FV= 1,000

PV= -1,010.50

N= 10

PMT= 50

Press the CPT key and I/Y to compute the yield to maturity.

The answer obtained is 4.8649.

Therefore, the yield to maturity is 4.86%.

g.The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) which is calculated using the formula below:

Ke=Rf+b[E(Rm)-Rf]

where:

Rf=risk-free rate of return

Rm=expected rate of return on the market.

b= stock’s beta

Ke= 2% + 1.1*(8% - 2%)

= 2% + 6.60%

= 8.60%

h.Weight of debt in the firm's capital structure=

The weighted average cost of capital is calculated using the below formula:

WACC=Wd*Kd(1-t)+ We*Ke

where:

Wd= Percentage of debt in the capital structure.

Kd= The before tax cost of debt

We=Percentage of equity in the capital structure

Ke= The cost of common equity.

T= Tax rate

WACC= 0.2520*4.86%*(1 - 0.25) + 0.7480*8.60%

= 0.2520*3.6450% + 0.7480*8.60%

= 0.9185% + 6.4328%

= 7.3513% 7.35%.