Question

Using the following data:

• Debt
  • Market value - $7,000,000
  • Current yield to maturity – 8%
• Equity
  • Market value - $35,000,000
• Tax rate – 35%
• Expected return on market – 10%
• Current 10 year US Treasury – 2.3%
• Beta – 1.60

Calculate weighted average cost of capital

Answer 1

Information provided:

Market value of debt= $7,000,000

Market value of equity= $35,000,000

Current yield to maturity= 8%

Tax rate= 35%

Expected return on the market= 10%

Risk free rate= 2.30% (current 10 year US treasury)

Beta= 1.60

The weighted average cost of capital is calculated using the below formula:

= wd*kd(1-t)+we*ke

where:

Wd=percentage of debt in the capital structure

We=percentage of equity in the capital structure

Kd=cost of debt

Ke=cost of equity

t= tax rate

The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) which is calculated using the formula below:

Ke= Rf+b[E(Rm)-Rf]

where:

Rf=risk-free rate of return which is the yield on default free debt like treasury notes

Rm=expected rate of return on the market.

b= stock’s beta

Ke= 2.30 + 1.60*(10 – 2.30)

     = 2.30 + 1.60*7.70

     = 2.30 + 12.32

     = 14.62%

Total capital= Market value of debt + Market value of equity

                        = $7,000,000 + $35,000,000

                        = $42,000,000

Proportion of debt in the capital structure= $7,000,000/ $42,000,000

                                                                                 = 0.1667*100= 16.67%

Proportion of equity in the capital structure= $35,000,000/ $42,000,000

                                                                                     = 0.8333*100= 83.33%

WACC= 0.1667*8%*(1-0.35) + 0.8333*14.62%

         = 0.1667*5.20% + 0.8333*14.62%

         = 0.8668 + 12.1828

         = 13.0496 13.50%   

Therefore, the weighted average cost of capital is 13.50%.

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