Question

A company 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 $1,050.00. (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?

Answer 1

Weighted Average Cost of Capital (WACC)

After-Tax Cost of Debt

After-Tax Cost of Debt is the After-Tax Yield to Maturity (YTM) of the Bond

Par Value = $1,000

Annual Coupon Amount = $80 [$1,000 x 8%]

Bond Price = $1,050

Maturity Period = 20 Years

Therefore, Yield to Maturity [YTM] = Coupon Amount + [(Par Value – Bond Price) / Maturity Years] / [(Par Value + Bond Price)/2]

= [$80 + {($1,000 – $1050) / 20 Years)] / [($1,000 + $1050) / 2}]

= [($80 - $2.50) / $1025]

= 0.0751 or

= 7.51%

After Tax Cost of Debt = Bond’s YTM x [ 1 – Tax Rate]

= 7.51% x (1 – 0.40)

= 7.51% x 0.60

= 4.51%

Cost of Common Equity

As per Capital Asset Pricing Model [CAPM], The cost of equity is calculated by using the following formula

Cost of Equity = Risk-free Rate + [Beta x Market Risk Premium]

= 4.50% + [1.20 x 5.50%]

= 4.50% + 6.60%

= 11.10%

Weighted Average Cost of Capital (WACC)

Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of common equity x Weight of Equity]

= [4.51% x .35] + [11.10% x 0.65]

= 1.58% + 7.21%

= 8.79%

“Therefore, the Weighted Average Cost of Capital (WACC) = 8.79%”