Question

Question 1

A company has $400 million worth of debt outstanding with an average interest rate of 5% and 50 million common shares outstanding worth $12 each. The company’s tax rate is 28%, beta is 1.3, the yield on 10-year Treasury notes is 1.5% and the expected market return is 9.5%. What is the company’s weighted average cost of capital (WACC) based on the current weights for debt and common stock in its capital structure?

		a. 7.98%
		b. 8.10%
		c. 8.26%
		d. 8.58%
		e. 8.74%

Answer 1

Current Value of Debt Outstsanding = $ 400 Million

Price of Share = $12

No. of Shares = 50 Million

Now Total Share's Value = Price of Share x No. of Shares

Now Total Share's Value = $ 12 * 50 Million = $ 600 Million

Weight of Debt = Value of Debt / Value of Debt + Value of Equity

Weight of Debt = 400 / 600 + 400 = 40%

Weight of Equity = 1- Wieght of Debt = 60%

Now given the pre tax cost of Debt = Average Interest Rate = 5%

Tax Rate = 28%

Post Tax Cost of Debt = Pre tax Rate * (1- Tax Rate)

Post Tax Cost of Debt = 5% * (1-0.28) = 3.6%

According to CAPM or Capital Asset Pricing Model

Required Return of Stock = Risk Free Rate + (Market Return - Risk Free Rate)* Beta of Stock

Where we have

Treasure Note Yields = 1.5% = Risk Free Rate

Market Return = 9.5%

Beta of the stock = 1.3

Therefore Required Retrun of Stock = 1.5 + (9.5-1.5)*1.3

Required Retrun of Stock = 11.9%

Now, WACC = Weight of Debt * Cost of Debt + Weight of Equity * Cost of equity

Therefore WACC = 0.40 *3.6% + 0.60*11.9%

WACC = 8.58%