Question

Parole Co. has 77,910 bonds outstanding that are selling at par value. The bonds yield 8.5 percent. The company also has 5.4 million shares of common stock outstanding. The stock has a beta of 1.2 and sells for $46.3 a share. The U.S. Treasury bill is yielding 3.5 percent and the market risk premium is 8.3 percent. Parole's tax rate is 32 percent. What is the firm's weighted average cost of capital? Enter answer in percents.

Answer 1

Market Value of Debt and Equity

Market Value of Debt = $77,910,000 [77,910 Bonds x $1,000 per Bond]

Market Value of Equity = $250,020,000 [5,400,000 Common shares x $46.30 per share]

Total Market Value = $327,930,000

Weight of Capital Structure

Weight of Debt = 0.2376 [$77,910,000 / $327,930,000]

Weight of Equity = 0.7624 [$250,020,000 / $327,930,000]

After-tax Cost of Debt

After-tax Cost of Debt = Bonds Yield to Maturity x (1 – Tax Rate)

= 8.50% x (1 – 0.32)

= 8.50% x 0.68

= 5.78%

Cost of Equity

As per Capital Asset Pricing Model [CAPM], The Expected Required rate of return is computed by using the following equation Cost of Equity = Risk-free Rate + [Beta x Market Risk Premium]

= 3.50% + [1.2 x 8.30%]

= 3.50% + 9.96%

= 13.46%

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]

= [5.78% x .2376] + [13.46% x 0.7624]

= 1.38% + 10.26%

= 11.64%

“Hence, the firm's weighted average cost of capital will be 11.64%”