Question

A company XYZ needs 1 million € worth of funds. It issues bonds

worth 100,000 €. Each bond has a par value of 1000 € and a coupon

rate of 5% each year for 10 years. The current market price of the

bond is 850 €. Remaining amount company raises by selling shares.

The required rate of return on its shares is 8% and the marginal tax

rate is equal to 20%. Calculate the WACC?

part b):

BB industries’ share has a beta of 0.8. The risk-free rate is 4% and the

expected return on the market is 12%. BB industries is funding 60% of

its investments from shares and the rest from bonds. The marginal tax

rate is equal to 15%. The yield to maturity on its bonds is 7%.

Calculate the WACC.

Answer 1

Part a)

First we need t calculate the market value of bonds

Therefore

No. Of bonds = Total Value of bond / par value of each bond

= 100000 / 1000

= 100

Now market value = No. of bonds * Current market price of each bond

= 100 * 850

= € 85000

Remaining fund will come from equity = € 1000000 - € 850000

= € 915000

Now we need to work out the WACC Using

W A C C = Ke * We + Kd * Wd * ( 1 - T ).

Where,

Ke = Cost of Equity = 8%

We = Weight of Equity = Equity value / Total value = 915000 / 1000000 = 0.915

Kd = Cost of Debt = 5%

Wd = Weight of Debt = Debt value / Total value = 85000 / 1000000 = 0.085

and T = Tax Rate = 20%

Put the above value in the formula we get

WACC = ( 8 * 0.915) + {0.05 * (1 - 0.20) * 0.085}

= 7.32 + 0.0034

WACC = 7.323%

Part b)

Here we first need to calculate cost of equity using CAPM

Cost of equity = Rf + (Rm - Rf) * Beta

where

Rf = 4%

Rm = 12%

Beta = 0.8

Put the values in formula we get

Cost of equity (Ke) = 4 + ( 12 - 4) * 0.8

= 4 + 6.4

= 10.4%

Now

W A C C = Ke * We + Kd * Wd * ( 1 - T ).

Where

Ke = 10.4%

We = 0.60

Kd = 7%

Wd = (1 - We) = ( 1 - 0.60) = 0.40

T = 15% = 0.15

Put the value and we get

WACC = 10.4 * 0.60 + 7 ( 1 - 0.15) *0.40

= 6.24 + 2.38

WACC = 8.62%