Question

Vang Enterprises. recently hired you as a consultant to estimate the company’s WACC. You have obtained the following information. (1) The firm's bonds mature in 10 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $945.00. (2) The risk-free rate is 1.25%, the market risk premium is 5.50%, and the stock’s beta is 1.40. (3) The target capital structure consists of 50% debt and 50% common equity. The firm uses the CAPM to estimate the cost of equity. (4) The company’s tax rate is 40%. What is its WACC?

a. 14.66%

b. 14.26%

c. 16.05%

d. 12.51%

e. 17.80%

Answer 1

Answer: WACC = 7.13%

Mark: b.)14.26%

It seems like while providing options they forgot to consider the weightage of debt and equity. So, their answer would be 14.26%. However, Correct answer is 7.13%

Calculation:

To arrive at WACC we need to find the cost of bond and equity.

The cost of bond is equal to the YTM of the bond.

Please find the attached images for the YTM calculation of the bod.

YTM of bond = 8.851%

According to CAPM model cost of equity = Rf + Beta * Market risk premium

Where Rf = Risk-free rate = 1.25

Beta = 1.4 and Market risk premium = 5.50%

Putting value in CAPM model...

1.25% + 1.4(5.5)

= 1.25 + 7.7= 8.95%

Cost of equity = 8.95%

WACC = Wd*Kd*(1-t) + We*Ke

where Wd = weightage of debt = 50%, Kd = cost of debt = 8.851%, t = tax rate = 40%

We = weightage of equity = 50%, Ke = Cost of equity = 8.95%

putting all the values into equation...

0.5*8.851*(1-0.4) + 0.5*8.95

= 2.6553 + 4.475

WACC = 7.13%

Please find the attached images for YTM calculation along with the formula

Hope this helps. Let me know if you need further assistance in any steps.

All the best!