In: Finance
Consider the following information:
1) Bonds outstanding: 80,000. Each bond sells at its $1,000 par value. The bonds are priced to provide a YTM of 8.6 percent.
2) Stock outstanding: 4 million shares. Current stock price = $40 per share. Book value = $28 per share. Current stock beta = 1.1.
3) The risk-free rate is 4%, the tax rate is 34%, and the expected return on the market portfolio is 12%.
What is the weighted average cost of capital (WACC)?
YTM of Bond = 8.6%.
Post Tax YtM of The Bond = YTM x (1-Tax Rate)
Post Tax YtM of The Bond = 8.6% (1-0.34) = 5.676%
Market Value of each bond = $ 1000
Total Market Value of Bond issued = No. of Bonds x Market Value of Bond = 80000 x 1000 = 80000000
No. of Shares = 4 Million Shares
Current Stock Price = $ 40
Now, Market Value of Equity = 40 * 4 Million Shares = 160000000.
Now, WACC = Wighted average cost of Capital = Weights of Debt x Post Tax YTM + Weight of Equity x Required Rate of Return
where weights are based on Market value of Debt and equity
Weight of Debt = Market Value of Debt/ Market Value of Debt + Equity
Weight of Equity = 1 - Weight of Debt
Weight of Debt = 80000000/160000000+80000000
Weight of Debt = 0.33
Weight of Equity = 0.67
Now According to CAPM Required Rate of Retrun of Stock = Risk Free Rate of Retrun + (Expected Return on Market - Risk Free Rate of Retrun) x Beta of Stock
According to CAPM Required Rate of Retrun of Stock = 4% + (12% - 4%) x1.1 = 12.8%
Now, WACC = 5.676% x 0.33 + 0.67 x 12.8% = 10.45%