Question

A firm has 2,000,000 shares of common stock outstanding with a market price of $2.00 per share. It has 2,000 bonds outstanding, each selling at 120% of a face value of $1000. The bonds mature in 15 years, have a coupon rate of 10%, and pay coupons annually. The firm's beta is 1.2., the riskfree rate is 5%, and market risk premium is 7%. The tax rate is 34%. Calculate the WACC

Answer 1

To calculate the WACC, the cost of equity and debt are blended based on the firm's capital structure. The cost of equity is found using CAPM and the cost of debt is calculated considering the market price of the bonds and the tax rate. The respective market values of equity and debt determine their proportions in the capital structure to find the WACC.

Step-by-step explanation:

To calculate the Weighted Average Cost of Capital (WACC) for the firm, we will first need to calculate the cost of equity and the cost of debt and then blend them proportionately based on the firm's capital structure. The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM), which is cost of equity = risk-free rate + (beta * market risk premium).

Given the risk-free rate of 5%, beta of 1.2, and market risk premium of 7%, the cost of equity is 5% + (1.2 * 7%) = 13.4%. The market value of equity is 2,000,000 shares * $2.00 per share = $4,000,000.

To calculate the cost of debt, we first need to determine the annual interest payment and the current market price of the bonds. Since each bond has a face value of $1000 with a 10% coupon rate, annual interest payments are $1000 * 10% = $100 per bond. With 2,000 bonds selling at 120% of face value, the total market value of debt is 2000 * $1000 * 120% = $2,400,000. The cost of debt before taxes is the annual interest payment divided by the market price of the bond, which after taxes is then adjusted by (1 - tax rate). This translates to ($100 / $1200) * (1 - 0.34) = 5.83%.

To find the proportions of equity and debt in the capital structure, the market values are used: equity proportion is $4,000,000 / ($4,000,000 + $2,400,000) = 0.625 and debt proportion is $2,400,000 / ($4,000,000 + $2,400,000) = 0.375. Finally, the WACC can be calculated by multiplying the cost of equity and debt by their respective proportions and summing the results: WACC = (0.625 * 13.4%) + (0.375 * 5.83%) = 10.0125%.

Answer 2

10.28 %

Step-by-step explanation:

WACC is the cost of all sources of capital pooled together. It shows the risk of the company or project.

WACC = Weight of Equity x Cost of Equity + Weight of Debt x Cost of Debt

where,

Weight of Equity = ($2.00 x 2,000,000) ÷ (($2.00 x 2,000,000) + (2,000 x $1,200)) = 0.625

Cost of Equity = Risk free rate + Beta x Market Risk Premium

= 5% + 1.2 x 7%

= 13.40 %

Weight of Debt = (2,000 x $1,200) ÷ (($2.00 x 2,000,000) + (2,000 x $1,200)) = 0.375

Cost of Debt is the Yield to Maturity (YTM) of the Bond

PV = ($1,200)

FV = $1,000

N = 15

PMT = $1,000 x 10% = $100

P/YR = 1

YTM = ?

Using a Financial Calculator, YTM is 7.71 %

We always use the after tax cost of debt ;

After tax cost of debt is 5.09 % that is [7.71 % x ( 1 - 0.34)]

therefore,

WACC = 13.40 % x 0.625 + 5.09 % x 0.375

= 10.28 %