Question

Suppose a firm has 34 million shares of common stock outstanding at a price of $15.5 per share. The firm also has 100,000 bonds outstanding with a current price of $1171.1. The outstanding bonds have yield to maturity 7.8%. The firm's common stock beta is 2.5 and the corporate tax rate is 38%. The expected market return is 12% and the T-bill rate is 1%. What is the WACC for this firm

Answer 1

The WACC is 24.197%

Step-by-step explanation:

The WACC or weighted average cost of capital is the cost of a firm's capital structure which can contain at least one or all of the following components namely debt, preferred stock and common stock. The WACC is calculated by taking the weighted average of these components and their respective costs to the firm.

The following is the formula for WACC,

WACC = wD * rD * (1-tax rate) + wP * rP + wE * rE

Where,

• w represents the weight of each component
• D is debt, P is preferred stock and E is common stock
• r represents the cost or rate of each component
• we take the after tax cost of debt so multiply the rate of debt by (1-tax rate)

First of all we need to calculate the cost of common stock. Using the CAPM equation, we calculate the cost of common stock to be,

rE = rRF + Beta * (rM - rRF)

Where,

• rRF is the risk free rate
• rM is the expected return of market

rE = 0.01 + 2.5 * (0.12 - 0.01)

rE = 0.285 or 28.5%

Now we determine the weight of both debt and common stock in the overall capital structure.

Total assets = 34000000 * 15.5 + 100000 * 1171.1 = 644110000 or 644.11 million

Total debt = 100000 * 1171.1 = 117110000 or 117.11 milion

Total common stock = 34000000 * 15.5 = 527000000 or 527 million

WACC = 117.11 / 644.11 * 0.078 * (1 - 0.38) + 527 / 644.11 * 0.285

WACC = 0.24197 or 24.197%