Question

A company has the following capital components:

Bonds- 20,000 bonds outstanding with a 8% coupon rate paid semiannually, 6 years to maturity, a $1,000 face value, and a $975 market price.

Common Stock- 500,000 shares trading $80 per share and have a beta of 1.5. The risk free rate is 4% and the market return is 12%

Assuming a 40% tax rate, what is the company's WACC?

Answer 1

Weighted average cost of capital or WACC can be calculated as under

Wacc = %debt*(debt cost)*(1-tax) + (%equity)*(cost of equity)

Total debt = number of bonds outstanding* market price

= 20000*975 = $19,500,000

Total equity = total shares outstanding*price

= 500,000*80 = $40,000,000

%of debt in total capital= 19,500,000/(19,500,000+40,000,000) = 0.3277

Thus, % debt is 32.77%

% equity in capital = 1-debt% = 1-0.3277 = 0.6723

Thus, equity % is 67.23%

Cost of equity can be found using capm as under

Cost of equity= risk free rate + beta*(market return - risk free return)

= 4+1.5*(12-4) = 16%

Thus cost of equity is 16%.

Cost of debt can be found by using =RATE function in excel.

8% coupon semiannual means 8*1000/2 or $40 coupon every 6 months. So PMT which is periodic payment is $40

6 years means 12 six monthly periods. So, nper which is period is 12.

Pv which is present value is -975.

Negative sign is used as cash flow signs are opposite.

Fv or future value is 1000. (Face value).

=Rate(nper,pmt,pv,fv)

= Rate(12,40,-975,1000)

=4.27%

Thus, cost of debt is 4.27% for 6 month period. So annual effective rate is 1.0427^2 - 1 = 8.72%

Thus, WACC = 0.3277*(1-0.40)*(8.72) + (0.6723*16) = 1.7145+10.7568 = 12.47%

Thus wacc is 12.47%.