Question

If Wild Widgets, Inc., were an all-equity company, it would have a beta of 1.15. The company has a target debt-equity ratio of .50. The expected return on the market portfolio is 12 percent and Treasury bills currently yield 3.1 percent. The company has one bond issue outstanding that matures in 24 years, a par value of $2,000, and a coupon rate of 5.8 percent. The bond currently sells for $2,150. The corporate tax rate is 22 percent.

a. What is the company's cost of debt? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
b. What is the company's cost of equity? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
c. What is the company's weighted average cost of capital? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
a. Cost of debt
b. Cost of equity
c. WACC

Answer 1

The cost of debt for Wild Widgets, Inc. involves calculating the yield to maturity on the company's outstanding bonds and adjusting for taxes. The cost of equity is determined using the CAPM method. The WACC takes both costs and weights them according to the firm's debt and equity structure.

Step-by-step explanation:

To determine the cost of debt, cost of equity, and the weighted average cost of capital (WACC) for Wild Widgets, Inc., several calculations are required based on financial theories and formulas.

Cost of Debt

The cost of debt is the after-tax yield to maturity on the company's bonds. The current yield can be approximated as the annual interest payment divided by the current bond price. To find the actual cost of debt, we use the yield to maturity (YTM) formula, which takes into account the coupon rate, time to maturity, face value, current price, and periodic payments.

YTM calculations are typically done using a financial calculator or an iterative process, as it involves solving for the rate that equalizes the present value of the bond's cash flows to its current market price. The after-tax cost of debt is then derived by multiplying the YTM by (1 - corporate tax rate).

Cost of Equity

We will use the Capital Asset Pricing Model (CAPM) to calculate the cost of equity. The formula is:

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

Where the market risk premium is the expected return on the market portfolio minus the risk-free rate, and Beta is the measure of the company's stock volatility in relation to the market.

Weighted Average Cost of Capital (WACC)

The WACC is calculated by weighing the cost of equity and the cost of debt by their respective proportions in the company's capital structure. The formula is:

WACC = E/V * Cost of Equity + D/V * Cost of Debt * (1 - Tax Rate)

Where E is the market value of equity, D is the market value of debt, and V is the total market value of the company's financing (Equity + Debt).

Calculating WACC involves deriving market values of equity and debt based on market data and the given debt-equity ratio.