Question

Easy Car Corp. is a grocery store located in the Southwest. Next year dividend is ​$2.00 and plans to increase the dividend annually at the rate of 3.0​%. It currently has 1,000,000 common shares outstanding. The shares currently sell for ​$10 each. Two years ago, Easy Car Corp. issued 40,000 semiannual 20-year bonds with a coupon rate of 8​% and a par value of ​$1,000. The bonds currently have a yield to maturity​ (YTM) of 11%. What is the weighted average cost of capital (WACC) for Easy Car Corp. if the corporate tax rate is 40%?

When answering this problem enter your answer using percentage notation but do not use the % symbol and use two decimals (rounding). For example, if your answer is 0.10469 then enter 10.47; if your answer is 10% then enter 10.00

Answer 1

Value of stock = D₁/(r-g)

Where, D₁ is the expected dividend next year

r is required return on equity

g is growth rate

$10 = $2/(r-0.03)

10r -0.3 = 2

r = 2.3/10

r = 0.23 or 23%

Since, bonds are issued two years ago, number of periods of semiannual bonds

= (20-2)*2

= 36

Semiannual coupon payment = (8%/2)*1000

= $40

Semi-annual YTM = 11%/2 = 5.5%

Price of Bond is calculated in excel below

Market value of Bonds = 40000*$766.9590

= $30678360

Market value of Equity = 1000000*$10

= $10000000

WACC = Cost of equity*(Market value of Equity/(Market value of Debt+ Market value of Equity)) + Cost of Debt*(1-Tax rate)*(Market value of Equity/(Market value of Debt+Market value of Equity))

WACC = 23*(10000000/(30678360+10000000)) + 11*(1-0.40)*(30678360/(30678360+10000000))

= 5.654 + 4.977

= 10.63