Question

Jack's Construction Co. has 80,000 bonds outstanding that are selling at par value. Bonds with similar characteristics are yielding 8.5 percent. The company also has 4 million shares of common stock outstanding. The stock has a beta of 1.1 and sells for $40 a share. The U.S. Treasury bill is yielding 4 percent and the market risk premium is 8 percent. Jack's tax rate is 35 percent. What is Jack's weighted average cost of capital?

Answer 1

Answer: 10.8%

Step-by-step explanation:

To calculate the weighted average cost of capital we use the following formula,

WACC = Ve/Vt * Re + Vd/Vt * Rd( 1 - tax rate)

Where,

Ve is the value of equity in the company

Vt is the total value of the company gotten by adding debt to Equity.

Re is the cost of Equity

Vd is the total value of debt in the company

Rd is the cost of debt

From the question above we have every variable except the Cost of Equity.

We can calculate that using the CAPM formula which is,

Re = rF + b(rM - rF)

Where,

rF is the risk free rate

b is beta

rM - rF is the market premium.

Plugging in the figures we have,

= 4% + 1.1 ( 8%)

= 12.8%

Now that we have the cost of debt we can go back to the original formula but first the value of Equity and debt need to be ascertained,

Value of debt = 80,000 * $1,000 ( par value)

= $80,000,000

Value of Equity = 4,000,000 * 40

= $160,000,000

Adding them up we have,

= $160 m + $80m

= $240m

WACC = Ve/Vt * Re + Vd/Vt * Rd( 1 - tax rate)

WACC = (160/240 * 12.8%) + (80/240 * 8.5%( 1 - 0.35)

WACC = 10.8%

Jack's weighted average cost of capital is 10.8%.