Question

Company Jedi AB has 10 million shares of equity outstanding. The current share price is 50 SEK, and the book value per share is 5 SEK.

The company also has two bond issues outstanding. The first bond issue has a face value of 100Million SEK (MSEK) and a 10 per cent annual coupon payment , sells for 90 per cent of par (face value of 1,000SEK), and matures in 1 year.

The second issue has a face value of £60 million and a 7.5 per cent annual coupon payment and sells for 96.5 per cent of par. Both bonds matures in 1 year. Note that in both bonds, there will be one coupon payment and face value.

Suppose the company’s equity has a beta of 2. The risk-free rate is 6 per cent, and the expected return on the market is 16 per cent. Assume that the overall cost of debt is the weighted average implied by the two outstanding debt issues. Both bonds make semi-annual payments. The tax rate is 35 per cent.

Calculate:

1. Return of Equity
2. YTM of each bond
3. The weighted average after-tax cost of debt
4. Company’s WACC?

Answer 1

Return of Equity

Return of equity can be found using Capital Asset Pricing Model (CAPM) Formula. As per CAPM,

Return of Equity = RF + (Beta *(RM-RF)) were

RF = Risk Free Rate = 6%

Beta = 2

RM = Expected Return on market = 16%

Return of Equity = 6%+(2*(16%-6%)) = 6%+(2*10%) = 6%+20% = 26%

YTM of each bond & the weighted average after-tax cost of debt

Workings:

Company's WACC:

Workings:

Note:

For the purpose of arriving at the Weighted Average Cost of Capital, either of market value weights or book value weights of equity and bonds can be considered. However, it is always more appropriate to use market value as weights. This is because the the primary purpose of arriving at cost of capital is to maximise investors value and by taking the market value as weights, interest of investors who would also have purchased it recently would have also been factored in.