Question

Suppose a firm has 33 million shares of common stock outstanding at a price of $40 per share. The firm also has 200,000 bonds outstanding with a current price of $1005.2. The outstanding bonds have yield to maturity 10.8%. The firm's common stock beta is 1.3 and the corporate tax rate is 36%. The expected market return is 12% and the T-bill rate is 6%.

1. What is the WACC for this firm?

Answer 1

12.89% or 13%

Step-by-step explanation:

WACC is the average cost of capital of the firm based on the weightage of the debt and weightage of the equity multiplied to their respective costs.

According to WACC formula

WACC = ( Cost of equity x Weightage of equity ) + ( Cost of debt ( 1- t) x Weightage of debt )

Market Values

Equity = 33,000,000 / $40 = $1,320,000,000

Bonds = 200,000 x $1,005.2 = $201,040,000

Total Market Value = $1,320,000,000 + $201,040,000 = $1,521,040,000

Weightage

Equity = $1,320,000,000 / $1,521,040,000 = 0.8678

Debt = $201,040,000 / $1,521,040,000 = 0.1322

Cost of equity

Capital asset pricing model measure the expected return on an asset or investment. it is used to make decision for addition of specific investment in a well diversified portfolio.

Formula for CAPM

Cost of equity = Risk free rate + beta ( Market return - Risk free rate )

Cost of equity = 6% + 1.3 (12%-6%) = 13.8%

Cost of Debt = YTM = 10.8%

Placing values in WACC formula

WACC = ( 13.8% x 0.8678 ) + ( 10.8% ( 1- 36%) x 0.1322 )

WACC = 11.98% + 0.91% = 12.89%