Question

7. Joe’s Pizza-In-A-Cup 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 10 years, have an 6.00% annual coupon, a par value of $1,000, and a market price of $1,100.00. (2) The company’s tax rate is 40%. (3) The risk-free rate is 4.00%, the market risk premium is 5.00%, and the stock’s beta is 1.20. (4) The target capital structure consists of 45% 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? Do not round your intermediate calculations.

Answer 1

Weight of equity = 1-D/A

Weight of equity = 1-0.45

W(E)=0.55

Weight of debt = D/A

Weight of debt = 0.45

W(D)=0.45

Cost of equity

As per CAPM

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

Cost of equity% = 4 + 1.2 * (5)

Cost of equity% = 10

Cost of debt

K = N

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

k=1

K =10

1100 =∑ [(6*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^10

k=1

YTM = 4.7223575927

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

After tax cost of debt = 4.7223575927*(1-0.4)

= 2.83341455562

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

WACC=2.83*0.45+10*0.55

WACC =6.77%