Question

DEC Inc. recently hired you as a consultant to estimate the company’s WACC. You have obtained the following information. (1) The firm's bonds have YTM of 10%. (2) The company’s tax rate is 40%. (3) The risk-free rate is 3.5%, the market risk premium is 5.5%, and the stock’s beta is 1.25. (4) The target capital structure has a debt-to-equity ratio equals to 1.5. The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new shares. What is its WACC?

Answer 1

The WACC for DEC Inc. is 11.745%.

Step-by-step explanation:

To calculate the WACC (Weighted Average Cost of Capital), we need to calculate the cost of equity and the cost of debt.

1. To calculate the cost of equity, we use the Capital Asset Pricing Model (CAPM) formula: Cost of Equity = Risk-Free Rate + Beta * Market Risk Premium.
2. Using the given information, the cost of equity is 3.5% + 1.25 * 5.5% = 10.875%.
3. To calculate the cost of debt, we use the pre-tax yield to maturity (YTM) on the firm's bonds. Since the YTM is 10% and the tax rate is 40%, the after-tax cost of debt is 10% * (1 - 0.4) = 6%.
4. Next, we calculate the weights of equity and debt in the capital structure. The debt-to-equity ratio is given as 1.5, which means the weight of debt is 1.5 / (1 + 1.5) = 0.6 and the weight of equity is 1 - 0.6 = 0.4.
5. Finally, we can calculate the WACC using the formula: WACC = (Weight of Equity * Cost of Equity) + (Weight of Debt * Cost of Debt).
6. Plugging in the values, the WACC is (0.4 * 10.875%) + (0.6 * 6%) = 8.145% + 3.6% = 11.745%.