Question

Jack’s Construction Co. has 80,000 bonds outstanding with annual coupon rate of 8.5% selling at par value. The bonds have 10 years to maturity. The company also has 4 million shares of common stock outstanding. The stock has a beta of 1.1 and sells for $40 a share. The risk free rate 4 percent and the market risk premium is 8 percent. Jack’s tax rate is 35 percent. What is Jack’s weighted average cost of capital?

Answer 1

Given about Jack's Construction Co.

company has 80,000 bonds outstanding with annual coupon rate of 8.5% selling at par value

Par value of the bond = $1000

=> Market price of the bond = $1000

Market value of debt = market price*number of bonds = 1000*80000 = $80000000 = $80 million

Pretax cost of debt Kd = 8.5%

Stock Beta = 1.1

Current price of stock = $40

number of shares = 4 million

=> Market value of equity = current price*number of share = 40*4 = $160 million

Risk free rate Rf = 4%

Market risk premium MRP = 8%

So, cost of equity using CAPM model is

Cost of equity Ke = Rf + Beta*MRP = 4 + 1.1*8 = 12.80%

Weight of debt Wd = Market value of debt/(MV of debt + MV of equity) = 80/(80+160) = 1/3 or 33.33%

Similarly weight of equity We = 1 - Wd = 1 - 1/3 = 2/3 or 66.67%

Tax rate T = 35%

So, Weighted average cost of capital = Wd*Kd*(1-T) + We*Ke = 0.3333*8.5*(1-0.35) + 0.6667*12.8 = 10.375%

So, Jack's Weighted average cost of capital is 10.38%