Question

Daves Inc. recently hired you as a consultant to estimate the company's WACC. You have obtained the following information: 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 $1,050.00 the company's tax rate is 40% the risk-free rate is 4.50% the market risk premium is 5.50% the stock's beta is 1.20 the target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new shares. Daves' WACC is closest to:

Answer 1

To calculate the WACC, you first need to find the cost of debt and the cost of equity. The cost of debt can be calculated using the yield to maturity of the company's bonds, while the cost of equity can be calculated using the CAPM. Once you have these values, you can calculate the WACC using the target capital structure.

Step-by-step explanation:

To calculate the Weighted Average Cost of Capital (WACC), we need to consider the cost of debt and the cost of equity. The cost of debt is the yield to maturity of the company's bonds. In this case, the bond has a par value of $1,000, an annual coupon rate of 8%, a maturity of 20 years, and a market price of $1,050. The yield to maturity can be calculated using the formula:

YTM = (Annual Coupon + ((Par Value - Market Price) / Years to Maturity)) / ((Par Value + Market Price) / 2)

Plugging in the values, the YTM is (80 + ((1,000 - 1,050) / 20)) / ((1,000 + 1,050) / 2) = 8.57%. Since the firm's tax rate is 40%, the after-tax cost of debt is 8.57% * (1 - 0.40) = 5.14%.

The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM). The CAPM formula is:

Cost of Equity = Risk-Free Rate + Beta * Market Risk Premium

Plugging in the values, the cost of equity is 4.50% + 1.20 * 5.50% = 11.50%.

Finally, to calculate the WACC, we use the formula:

WACC = (Weight of Debt * Cost of Debt) + (Weight of Equity * Cost of Equity)

Given the target capital structure of 35% debt and 65% equity, the WACC is (0.35 * 5.14%) + (0.65 * 11.50%) = 7.91%.

Answer 2

Step-by-step explanation:

First, find the YTM of the bond (rD), you can do this with a financial calculator using the following inputs;

Maturity of the bond : N = 20

Annual coupon payment; PMT = 8%*1000 = 80

Face value; FV = 1000

Price of the bond ; PV = -1,050

then CPT I/Y = 7.51% (this is the Pretax cost of debt; the rD)

Next, find the cost of equity (rE) using CAPM;

CAPM; r = risk free + beta (Market risk premium)

rE = 0.0450 + 1.20(0.0550)

rE = 0.0450 + 0.066

= 0.111 or 11.1%

Next, WACC formula = wE*rE + wD*rD(1-tax) whereby;

w = weight of..

rD= pretax cost of debt

WACC = (0.65*0.111) + [0.35*0.0751(1-0.40) ]

WACC = 0.07215 + 0.015771

= 0.0879

Therefore, WACC = 8.79%