Question

Daves Inc. recently hired you as a consultant to estimate the company's WACC. You have obtained the following information. (1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,000.00. (2) The company's tax rate is 25%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock's beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of equity, and it does not expect to issue any new common stock. What is its WACC? Do not round your intermediate calculations.

a. 9.32%

b. 6.76%

c. 10.32%

d. 11.03%

e. 8.90%

Answer 1

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

Information provided:

Face value= future value= $1,000

Market price= present value= $1,000

Time= 20 years

Coupon rate= 8%

Coupon payment= 0.08*$1,000= $80

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

FV= 1,000

PV= -1,000

N= 20

PMT= 80

  

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

The value obtained is 8.

Therefore, the yield to maturity is 8%.

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

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

where:

Rf=risk-free rate of return

Rm=expected rate of return on the market.

b= stock’s beta

Ke= 4.50% + 1.20*5.50%

= 4.50% + 6.60%

= 11.10%

WACC is calculated by using the formula below:

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= 0.35*8%*(1 - 0.25) + 0.65*11.10%

= 0.35*6% + 0.65*11.10%

= 2.10% + 7.22%

= 9.32%

Hence, the answer is option a.

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