Question

If Wild Widgets, Inc., were an all-equity company, it would have a beta of 1.8. The company has a target debt–equity ratio of .2. The expected return on the market portfolio is 8 percent, and Treasury bills currently yield 5.9 percent. The company has one bond issue outstanding that matures in 20 years and has a coupon rate of 10.8 percent. The bond currently sells for $1,270. The corporate tax rate is 35 percent. What is the company’s cost of debt? What is the company’s cost of equity? What is the company’s weighted average cost of capital? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

Weight of equity = 1-D/A

Weight of equity = 1-0.1667

W(E)=0.8333

Weight of debt = D/A

Weight of debt = 0.1667

W(D)=0.1667

Cost of equity

As per CAPM

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

Cost of equity% = 5.9 + 1.8 * (8 - 5.9)

Cost of equity% = 9.68

Cost of debt

K = N

Bond Price =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =20

1270 =∑ [(10.8*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^20

k=1

YTM = 8.04 = cost of debt

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 8.0414934655*(1-0.35)

= 5.226970752575

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=5.23*0.1667+9.68*0.8333

WACC =8.94%