Question

If it were unlevered, the overall firm beta for Wild Widgets Inc. (WWI) would be 1.7. WWI has a target debt/equity ratio of 1. The expected return on the market is 0.08, and Treasury bills are currently selling to yield 0.06. WWI one-year bonds (with a face value of $1,000) carry an annual coupon of 2% and are selling for $925.52. The corporate tax rate is 35%.(Round your answers to 2 decimal places before the percentage sign. (e.g., 10.23%))

a.	WWI’s before-tax cost of debt is  %.
b.	WWI’s cost of equity is  %.
c.	WWI’s weighted average cost of capital is  %.

Answer 1

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

levered beta = 1.7*(1+((1-0.35)*(1)))

levered beta = 2.81

D/A = D/(E+D)

D/A = 1.7/(1+1.7)

=0.6296

Weight of equity = 1-D/A

Weight of equity = 1-0.6296

W(E)=0.3704

Weight of debt = D/A

Weight of debt = 0.6296

W(D)=0.6296

Cost of equity

As per CAPM

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

Cost of equity% = 6 + 2.81 * (8 - 6)

Cost of equity% = 11.62

Cost of debt

K = N

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

k=1

K =1

925.52 =∑ [(2*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^1

k=1

YTM = 10.2083153254

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

After tax cost of debt = 10.2083153254*(1-0.35)

= 6.63540496151

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

WACC=6.64*0.6296+11.62*0.3704

WACC =8.48%