Question

You are employed by CGT, a Fortune 500 firm that is a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers. You are on the corporate staff as an assistant to the CFO. This is a position with high visibility and the opportunity for rapid advancement, providing you make the right decisions. Your boss has asked you to estimate the weighted average cost of capital for the company.

You check The Wall Street Journal and see that CGT stock is currently selling for $7.50 per share and that CGT bonds are selling for $875.00 per bond. The bonds have a S1,000 par value, a 7.25% annual coupon rate, semiannual payments, and a 20-year maturity. CGT's beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The expected return on the stock market is 11.50%. CGT is in the 40% tax bracket.

Further, the balance sheet and some other information about CGT follow below.

Assets

Current assets
Net plant, property, and equipment
Total assets
Liabilities and equity
Accounts payable
Accruals
Current liabilities
Long term debt (40,000 bonds, $1,000 par value) Total liabilities
Common stock (10,000,000 shares)
Retained earnings
Total shareholders equity
Total liabilities and shareholders equity

$ 38,000,000 101,000,000 $139,000,000

$ 10,000,000 9,000,000 $ 19,000,000 40,000,000 59,000,000 30,000,000 50,000,000 80,000,000 $139,000,000

       

Using the data above, answer the following questions:

1. What is the best estimate of the after-tax cost of debt for CGT?

2. Using the CAPM approach, what is the best estimate of the cost of equity for CGT?

3. What are the weights to be used when calculating the WACC?

4. What is the best estimate of the WACC for CGT?

Answer 1

What is the best estimate of the after-tax cost of debt for CGT?

It is the YTM on the company's outstanding bond.

Using the CAPM approach, what is the best estimate of the cost of equity for CGT?

Beta	1.25
Rf	5.50%
Rm	11.50%
CGT	40%
YTM	8.6%	<--Using rate formula in excel
CAPM	Rf+Beta*(Rm-Rf)
Cost of Equity	13.0%
Market value of Equity	75,000,000
Market value of debt	40,000,000
Total Debt+Equity	115,000,000	Weight of equity (Equity/Debt+Equity)
We	65%	Weight of debt (Debt/Debt+Equity)
Wd	35%
WACC	Ke*We+Kd*Wd(1-Tax rate)
10.27%

Using the CAPM approach, what is the best estimate of the cost of equity for CGT?

13% is the estimated cost of equity

What are the weights to be used when calculating the WACC?

We	65%
Wd	35%

What is the best estimate of the WACC for CGT?

10.27%

PLease reach out for any clarification