Question

If Wild Widgets, Inc., were an all-equity company, it would have a beta of .90. The company has a target debt-equity ratio of .60. The expected return on the market portfolio is 11 percent and Treasury bills currently yield 3.3 percent. The company has one bond issue outstanding that matures in 26 years, a par value of $2,000, and a coupon rate of 6 percent. The bond currently sells for $2,130. The corporate tax rate is 24 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.)

Answer 1

a. Cost of debt = 4.56%

b. Cost of equity = 10.23%

c. WACC = 8.46%

Step-by-step explanation:

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.)

Cost of debt = Coupon rate * (100% - tax rate ) = 6% * (100% - 24%) = 4.56%

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.)

Cost of equity = Risk free rate + (Beta * (Market rate - Risk free rate)) = 3.3% + (0.90 * (11% - 3.3%)) = 10.23%

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.)

WACC = (Cost of debt * Debt to total assets ratio) + (Cost of equity * Equity to total assets ratio) ………… (1)

Equity = Total assets - Debt

Debt to equity ratio = Debt / Equity = 0.60

0.60 = Debt / (Total assets - Debt)

0.60 * (Total assets - Debt) = Debt

0.60Total assets - 0.60Debt = Debt

0.60Total assets = Debt + 0.60Debt

0.60Total assets = (1 + 0.60)Debt

0.60Total assets = 1.60Debt

Debt / Total assets = 0.50 / 1.60 = 0.3125

Equity to total assets ratio = 1 - Debt to total assets = 1 - 0.3125 = 0.6875

Substituting all the relevant values into equation (1), we have:

WACC = (4.56% * 0.3125) + (10.23%* 0.6875) = 8.46%