Question

1. Calculate the weighted average cost of capital for a company given the following information:

Risk-free rate in the U.S.: 4%

Expected return on the U.S. market portfolio: 14%

Company’s risk relative to the market risk: 0.9

The company has 2-year, 12% bonds (paid semi-annually), face value of $1,000, selling for $1095.73.

The company’s marginal tax rate: 35%

The company finances 38% of its capital by debt and 62% by common equity.

2. Calculate the weighted average cost of capital for a company given the following information:

Price of the company’s common stock: $30.04

Dividend just been paid: $2.6

Expected perpetual constant growth rate: 4%

The company can borrow from its bank at 9% per year

The company’s marginal tax rate: 35%

The market value of the company’s assets is $160 million financed by $54.40 million in debt and the rest in equity

Answer 1

Answer :

As per the given questions, they were solved accordingly below :

1)  WACC = W(E) * Re + W(D) Rd (1-t)

W(E) = Proportion of equity finance ie., 62% = 0.62

W(D) = Proportion of debt finance i.e., 38% = 0.38

Re = Cost of equity = Risk free rate + Beta * ( Market rate of return - Risk free rate )

Beta = Company's risk relative to the market risk = 0.9

So, Re = 0.04 + 0.9 ( 0.14 - 0.04 ) = 0.13

Rd = Cost of capital for company issued debt, it accounts for interest a company pays on the issued bond

i.e., 12% = 0.12

WACC = 0.62 * 0.13 + 0.38 * 0.12 ( 1 - 0.35 )

    = 0.1102 i.e., 11.02%.

2) Market value of equity = 160 - 54.4 = 105.6

Weight of debt = 54.4 / 160 = 0.34

Weight of equity = 105.6 / 160 = 0.66

Cost of equity = ( D1 / share price ) + growth rate

Cost of equity = [ ( 2.6 * 1.04 ) / 30.04 ] + 0.04

  = 0.13 (or) 13%

WACC = 0.34 * 0.09 * ( 1 - 0.35 ) + 0.66 * 0.13

= 0.01989 + 0.0858

WACC = 0.1057 (or) 10.57%.