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

After-tax Cost of Debt

The After-tax Cost of Debt is the after-tax Yield to maturity of the Bond

The Yield to maturity of (YTM) of the Bond is calculated using financial calculator as follows (Normally, the YTM is calculated either using EXCEL Functions or by using Financial Calculator)

Variables	Financial Calculator Keys	Figure
Face Value [$1,000]	FV	1,000
Coupon Amount [$1,000 x 6%]	PMT	60
Yield to Maturity [YTM]	1/Y	?
Time to Maturity [10 Years]	N	10
Bond Price [-$1,100]	PV	-1,100

We need to set the above figures into the financial calculator to find out the Yield to Maturity of the Bond. After entering the above keys in the financial calculator, we get the yield to maturity (YTM) on the bond = 4.72%

After Tax Cost of Debt = Yield to maturity x (1 – Tax Rate)

= 4.72% x (1 – 0.40)

= 4.72% x 0.60

= 2.83%

Cost of Common Equity

As per Capital Asset Pricing Model [CAPM], The cost of common equity is computed by using the following equation

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

Risk-free Rate (Rf) = 4.00%

Market Risk Premium (Rm – Rf) = 5.00%

Beta = 1.20

Therefore, the Cost of Common Equity = Risk-free Rate + [Beta x Market Risk Premium]

= 4.00% + [1.2 x 5.00%]

= 4.00% + 6.00%

= 10.00%

Weighted Average Cost of Capital (WACC)

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

= [2.83% x 0.45] + [10.00% x 0.55]

= 1.27% + 5.50%

= 6.77%

“Therefore, the Company’s Weighted Average Cost of Capital (WACC) will be 6.77%”