Question

Upton Umbrellas has a cost of equity of 11.3 percent, the YTM on the company's bonds is 5.9 percent, and the tax rate is 40 percent. The company's bonds sell for 93.3 percent of par. The debt has a book value of $399,000 and total assets have a book value of $949,000. If the market-to-book ratio is 2.65 times, what is the company's WACC?

Answer 1

The company's Weighted Average Cost of Capital (WACC) is approximately 9.68%.

To calculate the Weighted Average Cost of Capital (WACC) for Upton Umbrellas, follow these steps:

1. Calculate the Market Value of Equity:

- Given the market-to-book ratio (M/B) of 2.65, you can find the market value of equity (MVE):

`\[MVE = M/B * Book Value of Equity\]`

`\[MVE = 2.65 * (Book Value of Equity)/(1 - Debt Ratio)\]`

Since the Debt Ratio is given by
`\[Debt Ratio = (Book Value of Debt)/(Total Assets)\],` you can calculate it.

`\[Debt Ratio = (399,000)/(949,000)\]`

Calculate the market value of equity (MVE).

2. Calculate the Market Value of Debt:

- Given that the bonds sell for 93.3% of par, you can find the market value of debt (MVD):

`\[MVD = \text{Bonds' Selling Price} * \text{Number of Bonds Issued}\]`

`\[MVD = 0.933 * (Book Value of Debt)/(Bond Price)\]`

Calculate the market value of debt (MVD).

3. Calculate the Total Market Value of Capital (TMV):

- TMV is the sum of MVE and MVD.

4. Calculate the Weight of Equity (WE) and Weight of Debt (WD):

-
`\[WE = (MVE)/(TMV)\]`

-
`\[WD = (MVD)/(TMV)\]`

5. Calculate the After-Tax Cost of Debt (Kd):

- Given the Yield to Maturity (YTM) on the company's bonds and the tax rate, you can find the after-tax cost of debt:

`\[Kd = YTM * (1 - \text{Tax Rate})\]`

6. Calculate WACC:

- WACC is the weighted average of the cost of equity (Ke) and the after-tax cost of debt (Kd):

`\[WACC = (WE * Ke) + (WD * Kd)\]`

Now, let's calculate it step by step:

1. Calculate the Debt Ratio:

`\[Debt Ratio = (399,000)/(949,000) = 0.42043755\]`

2. Calculate MVE:

`\[MVE = 2.65 * (399,000)/(1 - 0.42043755) \approx 1,423,355.59\]`

3. Calculate MVD:

`\[MVD = 0.933 * (399,000)/(0.933) \approx 399,000\]`

4. Calculate TMV:

`\[TMV = MVE + MVD \approx 1,823,355.59\]`

5. Calculate WE and WD:

`\[WE = (1,423,355.59)/(1,823,355.59) \approx 0.7796\]`

`\[WD = (399,000)/(1,823,355.59) \approx 0.2204\]`

6. Calculate Kd:

`\[Kd = 0.059 * (1 - 0.40) = 0.0354\]`

7. Calculate WACC:

`\[WACC = (0.7796 * 0.113) + (0.2204 * 0.0354) \approx 0.0968\]`

So, the company's Weighted Average Cost of Capital (WACC) is approximately 9.68%.