Question

Davenport Inc. has a target capital structure of 35% debt, and 65% of common equity. The current price of the firm's 7% coupon, semiannual payment, non-callable bonds with 10 years remaining maturity is $1,100. New bonds would be privately placed with a flotation cost equally to 4% of the proceeds on a new issue of bond. The firm's cost of common equity is estimated to be 12%. The corporate tax rate is 40%.

Required:
a. What is the firm’s before-tax cost of debt financing?
b. What is the firm’s WACC?

Answer 1

a.

6.24%

b.

9.11%

Step-by-step explanation:

a.

P = [ C x ( 1 - ( 1 + r )^-n ) / r ] + [ F / ( 1 + r )^n ]

Where

F = Face value = $1,000

P = Price = Price x ( 1 - Floatation cost rate ) = $1,100 x ( 1 - 4% ) = $1,056

C = Coupon payment = Face value x Coupon rate x semiannual fraction = $1,000 x 7% x 6/12 = $35

n = numbers of periods = Numbers of years to maturity x coupon payment per year = 10 years x 2 periods per year = 20 periods

r = YTM x 6/12 = r/2

Placing values in the formula

$1,056 = [ $35 x ( 1 - ( 1 + r/2 )^-20 ) / r/2 ] + [ $1,000 / ( 1 + r/2 )^20 ]

r = 3.1194% x 2 = 6.23885% = 6.24%

b.

Now use the following formula to calculate WACC

WACC = ( Cost of Equity x Wight of equity ) + ( After tax Cost of debt x Weight of debt )

WACC = ( 12% x 65% ) + ( 6.24% x ( 1 - 40% ) x 35% )

WACC = 7.80% + 1.31%

WACC = 9.11%