Question

Daves Inc. recently hired you as a consultant to estimate the company's WACC. You have obtained the following information. (1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,225.00. (2) The company's tax rate is 40%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock's beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of equity, and it does not expect to issue any new common stock. What is its WACC? Do not round your intermediate calculations.

a. 10.01%

b. 7.80%

c. 6.79%

Answer 1

Before Tax Cost of Debt = [Coupon+{(Redemption Price-Issue Price)/Term}]/[(Redemption Price+Issue Price)/2]

Coupon = Par Value*Coupon Rate = 1000*8% = $80

Redemption Price (assumed, redeeming at par) = $1000

= [80+{(1000-1225)/20}]/[(1000+1225)/2]

= 68.75/1112.5

= 0.061798 = 6.1798%

After Tax Cost of Debt = Before Tax Cost of Debt*(1-Tax Rate) = 6.1798*(1-40%) = 3.7079%

Before Tax Cost of Debt = [Coupon+{(Redemption Price-Issue Price)/Term}]/[(Redemption Price+Issue Price)/2]

Coupon = Par Value*Coupon Rate = 1000*8% = $80

Redemption Price (assumed, redeeming at par) = $1000

= [80+{(1000-1225)/20}]/[(1000+1225)/2]

= 68.75/1112.5

= 0.061798 = 6.1798%

After Tax Cost of Debt = Before Tax Cost of Debt*(1-Tax Rate) = 6.1798*(1-40%) = 3.7079%

Before Tax Cost of Debt = [Coupon+{(Redemption Price-Issue Price)/Term}]/[(Redemption Price+Issue Price)/2]

Coupon = Par Value*Coupon Rate = 1000*8% = $80

Redemption Price (assumed, redeeming at par) = $1000

= [80+{(1000-1225)/20}]/[(1000+1225)/2]

= 68.75/1112.5

= 0.061798 = 6.1798%

After Tax Cost of Debt = Before Tax Cost of Debt*(1-Tax Rate) = 6.1798*(1-40%) = 3.7079%

Before Tax Cost of Debt = [Coupon+{(Redemption Price-Issue Price)/Term}]/[(Redemption Price+Issue Price)/2]

Coupon = Par Value*Coupon Rate = 1000*8% = $80

Redemption Price (assumed, redeeming at par) = $1000

= [80+{(1000-1225)/20}]/[(1000+1225)/2]

= 68.75/1112.5

= 0.061798 = 6.1798%

After Tax Cost of Debt = Before Tax Cost of Debt*(1-Tax Rate) = 6.1798*(1-40%) = 3.7079%

Before Tax Cost of Debt = [Coupon+{(Redemption Price-Issue Price)/Term}]/[(Redemption Price+Issue Price)/2]

Coupon = Par Value*Coupon Rate = 1000*8% = $80

Redemption Price (assumed, redeeming at par) = $1000

= [80+{(1000-1225)/20}]/[(1000+1225)/2]

= 68.75/1112.5

= 0.061798 = 6.1798%

After Tax Cost of Debt = Before Tax Cost of Debt*(1-Tax Rate) = 6.1798*(1-40%) = 3.7079%

As per CAPM,

Expected Return = Risk Free Rate + Beta[Market Risk Premium] = 4.5%+1.2[5.5%] = 4.5%+6.6% = 11.1%

WACC = Sum of [Weight*Cost] = [35%*3.7079]+[65%*11.1] = 1.2978+7.215 = 8.5128%

Note: Although, there is no option of 8.5128%, I have rechecked the answer and it is 8.5128% only.