Question

Given the following information about your firm’s capital structure, calculate your firm’s WACC (assume the corporate tax rate is 35%). Debt Number of bonds outstanding = 12,000 price per bond = $1,165 par value per bond = $1,000 coupon rate = 6% (paid annually) Years to maturity = 10 Common Stock Number of shares outstanding = 1,000,000 Price per share = $25 Book value per share = $15 Beta = 1.4 Risk free rate = 4.5% Market risk premium = 5% a. 7.54% b. 8.15% c. 8.66% d. 8.30% e. 9.12%

Answer 1

Market value of debt= $1,165*12,000= $13,980,000.

Market value of equity= $25*1,000,000= $25,000,000

Total firm value= $13,980,000 + $25,000,000 = $38,980,000.

Weight of debt in the capital structure= $13,980,000/ $38,980,000

                                                                           = 0.3586*100

                                                                           = 35.86%

Weight of equity in the capital structure= $25,000,000/ $38,980,000

                                                                             = 0.6414*100

                                                                             = 64.14%

The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) which is calculated using the formula below:

Ke=Rf+[E(Rm)-Rf]

Where:

Rf=risk-free rate of return

Rm=expected rate of return on the market.

Rm- Rf= Market risk premium

= stock’s beta

Ke= 4.5% + 1.4*5%

     = 4.5% + 7%

     = 11.50%

The cost of debt is calculated by computing the yield to maturity.

Par value= future value= $1,000

Current price= market value= $1,165

Coupon rate= 6%

Coupon payment= 0.06*1,000= $60

Time= 10 years

The yield to maturity is calculated by entering the below in a financial calculator:

FV= 1,000

PV= 1,165

PMT= 60

N= 10

Press the CPT key and I/Y to compute the yield to maturity.

The value obtained is 3.9689.

Therefore, the yield to maturity is 3.97%.

WACC= wd*kd(1-t)+we*ke

Where:

Wd=percentage of debt in the capital structure

We=percentage of equity in the capital structure

Kd=cost of debt

Ke=cost of equity

t= tax rate

WACC= 0.3586*3.97*(1- 0.35) + 0.6414*11.50%

            = 0.9254 + 7.3761

            = 8.30158.30%.

           

Hence, the answer is option d.

In case of any query, kindly comment on the solution.