Final answer:
To calculate Scroggs Corporation's WACC, the cost of debt (after taxes) and the cost of equity must be found and then weighted by the firm's target capital structure. The after-tax cost of debt is based on the yield to maturity of the bonds and the company's tax rate. The cost of equity is estimated with the CAPM formula, considering the risk-free rate, market risk premium, and the stock's beta.
Step-by-step explanation:
To estimate Scroggs Corporation's weighted average cost of capital (WACC), you need to calculate the cost of debt (after taxes) and the cost of equity, and then weight them according to the firm's target capital structure. The cost of debt can be found by using the yield to maturity approach or by adjusting the market interest rate for taxes. However, the cost of equity is typically estimated using the Capital Asset Pricing Model (CAPM).
The cost of debt is the after-tax yield to maturity on the firm's current debt. Since the bonds in question have an annual coupon of 8% and are priced at $1,050 with a par value of $1,000, their pre-tax yield to maturity will be slightly less than 8% because the bonds are selling at a premium. The after-tax cost of debt would be this yield to maturity multiplied by (1 - tax rate).
The cost of equity can be estimated using the CAPM, which is defined as: Cost of Equity = Risk-Free Rate + (Beta * Market Risk Premium). You provided all the necessary inputs: a risk-free rate of 4.50%, a market risk premium of 5.50%, and a beta of 1.20. Plugging these figures into the CAPM formula gives us the company's cost of common equity.
After calculating both the cost of debt and the cost of equity, the WACC can be computed by weighting these costs by the proportions of debt and equity in the firm's target capital structure. Since the firm's target structure consists of 35% debt, the remainder of 65% would be common equity. The WACC is the sum of: 35% * cost of debt + 65% * cost of equity.