Question

A firm has issued 40,000 shares of stock whose current price is $81 per share. Shareholders expect an annual return of 15%. The firm also has a two-year loan of $1,800,000 at 6.4% annual interest. It has also issued 8,500 bonds with a face value of $1,000 each, with 15 years left to maturity, semi-annual compounding, and a coupon interest rate of 5%. The bonds are currently worth (have a current market price of) $1,100 each on the market.(a) Using market values for its debt and equity, calculate the firm's weighted-average cost of capital (WACC) before taxes. Round to tenths place (e.g., 12.8%) (b) Assume a tax rate of 38% applies. Calculated the WACC after accounting for the impact taxes have with same rounding)

Answer 1

(a) WACC before tax is 7.43%

(b) WACC after tax is 5.89%

Step-by-step explanation:

WACC = Value of equity * cost of equity/ (Value of equity & debt) + Value of debt * cost of debt/ (Value of equity & debt)

Value of equity = number of share * current price = 40,000 * $81 = $3,240,000

Market value of bond = $1,100 * 8,500 = $9,350,000

Market value of equity & debt = $3,240,000 + $1,800,000 + $9,350,000 = $14,390,000

(a) WACC before tax = 3,240,000 * 15%/ 14,390,000 +1,800,000 * 6.4%/ 14,390,000 + 9,350,000 * 5%/ 14,390,000 = 7.43%

(b) If tax rate is 38%, then cost of debt is changed as below:

Cost of two-year loan = 6.4%* (1-38%) = 3.97%

Cost of bond = 5% * (1-38%) = 3.1%

WACC after tax = 3,240,000 * 15%/ 14,390,000 +1,800,000 * 3.97%/ 14,390,000 + 9,350,000 * 3.1%/ 14,390,000 = 5.89%