Question

Hero Manufacturing has 7.6 million shares of common stock outstanding. The current share price is $86 and the book value per share is $5. The company also has two bond issues outstanding. The first bond issue has a face value of $75 million, a coupon rate of 6.4 percent and sells for 106.7 percent of par. The second issue has a face value of $60.5 million, a coupon rate of 6.9 percent and sells for 110.5 percent of par. The first issue matures in 9 years, the second in 25 years.

Suppose the company’s stock has a beta of 1.3. The risk-free rate is 2.9 percent and the market risk premium is 6.8 percent. Assume that the overall cost of debt is the weighted average implied by the two outstanding debt issues. Both bonds make semiannual payments. The tax rate is 23 percent. What is the company’s WACC?

Answer 1

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

MV of equity=86*7600000

=653600000

MV of Bond1=Par value*bonds outstanding*%age of par

MV of Bond1=1000*75000*1.067

=80025000

MV of Bond2=Par value*bonds outstanding*%age of par

MV of Bond2=1000*60500*1.105

=66852500

MV of firm = MV of Equity + MV of Bond1+ MV of Bond 2

=653600000+80025000+66852500

=800477500

Weight of equity = MV of Equity/MV of firm

Weight of equity = 653600000/800477500

W(E)=0.8165

Weight of debt = MV of Bond/MV of firm

Weight of debt = 146877500/800477500

W(D)=0.1835

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (Market risk premium)

Cost of equity% = 2.9 + 1.3 * (6.8)

Cost of equity% = 11.74

Cost of debt

Bond1

K = Nx2

Bond Price =∑ [(Semi Annual Coupon)/(1 + YTM/2)^k]     +   Par value/(1 + YTM/2)^Nx2

k=1

K =9x2

1067 =∑ [(6.4*1000/200)/(1 + YTM/200)^k]     +   1000/(1 + YTM/200)^9x2

k=1

YTM1 = 5.4482841271

Bond2

K = Nx2

Bond Price   =∑ [(Semi Annual Coupon)/(1 + YTM/2)^k]     +   Par value/(1 + YTM/2)^Nx2

k=1

K =25x2

1105 =∑ [(6.9*1000/200)/(1 + YTM/200)^k]     +   1000/(1 + YTM/200)^25x2

k=1

YTM2 = 6.08

Firm cost of debt=YTM1*(MV bond1)/(MV bond1+MV bond2)+YTM2*(MV bond2)/(MV bond1+MV bond2)

Firm cost of debt=5.4482841271*(80025000)/(80025000+66852500)+6.08*(80025000)/(80025000+66852500)

Firm cost of debt=5.74%

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

After tax cost of debt = 5.74*(1-0.23)

= 4.4198

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

WACC=4.42*0.1835+11.74*0.8165

WACC =10.4%