Question

ABC Corporation has $100 million in debt outstanding. The debt has 4 years to maturity and a 6% coupon. The debt has a par value of $1,000 per bond and interest is paid semi-annually. The current price of the bond is 105.25 as a percent of par.

The company has 10 million of stock outstanding with a market price of $25 per share. The stock has a beta of 1.24 with the market.  

The company is in the 25% tax bracket and the risk-free rate is 4% with a 6% market risk premium.

What is the weighted average cost of capital (WACC) for ABC Corporation?

Group of answer choices

14.32%

5.12%

9.15%

12.82%

Answer 1

Market value of equity E = Number of shares * stock price = 10 million *$25 = $250 million

Market value of debt D = Debt outstanding * selling at % of par

= $100 million * 105.25% = $105.25 million

Firm’s market value capital structure = Market value of equity E + Market value of debt D

(D +E)= $250 million +$105.25 million

= $355.25 million

We need to find the YTM on bond issues

Before tax cost of debt is bond’s yield; we have following formula for calculation of bond’s yield

Bond price P0 = C* [1- 1/ (1+i) ^n] /i + M / (1+i) ^n

Where

Price of the bond P0 = $105.25 million

M = value at maturity, or par value = $100 million

C = coupon payment = 6%/2 of $100 million = $3,000,000 semiannual coupon

n = number of payments = 4 years *2 = 8

i = interest rate, or yield to maturity =?

Now we have,

$105.25 million = $3,000,000 * [1 – 1 / (1+i) ^8] /i + $100 million / (1+i) ^8

We got the value of i = 2.27%

Therefore YTM of bond = 2 *2.27% = 4.55%

Tax rate = 25%

Therefore After tax cost of debt rd = 4.55% *(1-0.25) = 3.41%

re= the firm's cost of equity = risk free rate (rf) + β of stock * risk premium on the market

= 4% + 1.24 * 6% = 11.44%

Weighted Average Cost of Capital (WACC)

WACC = [E/ (E+D)] * re + [D/ (E+D)] * rd

Where, re is the cost of equity

rd is the after tax cost of debt

E is the value of common equity

D is the value of debt

WACC = ($ 250 million / $355.25 million) * 11.44% + ($105.25 million / $355.25 million) * 3.41%

= 9.15%

Therefore the Weighted Average Cost of Capital (WACC) is 9.15%