Question

GFC’s balance sheet shows a total of $25 million long-term debt with a coupon rate of 8.50%. The yield to maturity on this debt is 8.00%, and the debt has a total current market value of $27 million. The company has 10 million shares of stock, and the stock has a book value per share of $5.00. The current stock price is $20.00 per share, and stockholders' required rate of return, r_s, is 12.25%. The company recently decided that its target capital structure should have 35% debt and 65% common equity. The tax rate is 40%. Calculate WACCs based on book, market, and target capital structures. What is the sum of these three WACCs?

Answer 1

WACC based on target capital structures

Weight of equity = 1-D/A

Weight of equity = 1-0.35

W(E)=0.65

Weight of debt = D/A

Weight of debt = 0.35

W(D)=0.35

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

After tax cost of debt = 8*(1-0.4)

= 4.8

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

WACC=4.8*0.35+12.25*0.65

WACC =9.64%

WACC based on market capital structures

MV of equity=Price of equity*number of shares outstanding

MV of equity=20*10000000

=200000000

MV of firm = MV of Equity + MV of Bond

=200000000+27000000

=227000000

Weight of equity = MV of Equity/MV of firm

Weight of equity = 200000000/227000000

W(E)=0.8811

Weight of debt = MV of Bond/MV of firm

Weight of debt = 27000000/227000000

W(D)=0.1189

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

After tax cost of debt = 8*(1-0.4)

= 4.8

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

WACC=4.8*0.1189+12.25*0.8811

WACC =11.36%

WACC based on book capital structures

BV of equity=Price of equity*number of shares outstanding

BV of equity=5*10000000

=50000000

BV of firm = BV of Equity + BV of Bond

=50000000+25000000

=75000000

Weight of equity = BV of Equity/BV of firm

Weight of equity = 50000000/75000000

W(E)=0.6667

Weight of debt = BV of Bond/BV of firm

Weight of debt = 25000000/75000000

W(D)=0.3333

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

After tax cost of debt = 8*(1-0.4)

= 4.8

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

WACC=4.8*0.3333+12.25*0.6667

WACC =9.77%

Sum of 3 WACCs = 9.77+11.36+9.64=30.77%