Question

Heron Manufacturing (HM) has 50,000 bonds outstanding with a 7.0% per year coupon rate (with semi-annual coupon payments) and 10 years left to maturity. The bonds have a face value of $1,000 and currently sell for $982 per bond. HM's common stock has a beta of 1.2. The 10-year Treasury-Bond rate is currently 2.6%, and historically, the market has earned 6% more per year than the 10-year Treasury rate. HM has 4 million shares of common stock outstanding at a market price of $32.75/share (book value of $2 per share). The marginal tax rate for the company is 25%.

a. What is the before-tax cost of debt and what is the after-tax cost of debt? (2 answers)

b. What is the cost of common stock (cost of equity)?

c. What is the weighted average cost of capital for Heron Manufacturing?

Answer 1

a

Cost of debt

K = Nx2

Bond Price =∑ [(Semi Annual Coupon)/(1 + YTM/2)^k]     +   Par value/(1 + YTM/2)^Nx2

k=1

K =10x2

982 =∑ [(7*1000/200)/(1 + YTM/200)^k]     +   1000/(1 + YTM/200)^10x2

k=1

YTM = 7.26 = before tax cost of debt

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

After tax cost of debt = 7.2562452816*(1-0.25)

= 5.44

b

As per CAPM

Cost of equity = risk-free rate + beta * (Market risk premium)

Cost of equity% = 2.6 + 1.2 * (6)

Cost of equity% = 9.8

c

MV of equity=Price of equity*number of shares outstanding

MV of equity=32.75*4000000

=131000000

MV of Bond=Par value*bonds outstanding*%age of par

MV of Bond=1000*50000*0.982

=49100000

MV of firm = MV of Equity + MV of Bond

=131000000+49100000

=180100000

Weight of equity = MV of Equity/MV of firm

Weight of equity = 131000000/180100000

W(E)=0.7274

Weight of debt = MV of Bond/MV of firm

Weight of debt = 49100000/180100000

W(D)=0.2726

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

WACC=5.44*0.2726+9.8*0.7274

WACC =8.61%