Question

A company has 300,000 bonds outstanding that make semi-annual coupon payments currently trading at $1,010, with a 8% coupon rate and 15 years to maturity. In addition, the company has a current stock price of $54, five million shares outstanding, a 35% tax rate, a beta of 0.85, a risk-free rate of 2%, and an expected market return of 9%. What is the weighted average cost of capital (WACC)?

Answer 1

Given about a firm,

given about its common stock,

Number of shares outstanding = 5000000

current price P0 = $54

=> Market values of equity = price*shares = 54*5000000 = $270000000 or 270 million

stock beta = 0.85

risk free rate Rf = 2%

Expected market return Rm = 9%

Using CAPM, cost of equity is

Ke = Rf + Beta*(Rm - Rf) = 2 + 0.85*(9-2) = 7.95%

=> firm’s cost of common stock = 7.95%

its bonds has following feature,

Number of bonds outstanding = 300000

current price = $1010

=> Market values of debt = price*bonds = 1010*300000 = $303000000 or 303 million

Face value = $1000

coupon rate = 8% paid semiannually

So, semiannual coupon = (8%/2) of 1000 = $40

years to maturity = 15 years,

Yield to maturity of the bond can be calculated on financial calculator using following values:

FV = 1000

PV = -1010

PMT = 40

N = 2*15 = 30

Compute for I/Y, we get I/Y = 3.943

So, YTM of the bond = 2*3.943 = 7.89%

For a company, its pretax cost of debt Kd equals its bond's YTM

So, company's pretax cost of debt Kd = 7.89%

D). tax rate T = 35%

Weight of debt Wd = MV of debt/(MV of debt + MV of equity) = 303/(303+270) = 52.88%

Weight of equity We = MV of equity/(MV of debt + MV of equity) = 270/(303+270) = 47.12%

=> WACC of the company = Wd*Kd*(-T) + We*Ke = 0.5288*7.89*(1-0.35) + 0.4712*7.95 = 6.46%

=> firm’s weighted average cost of capital = 6.46%