159k views
3 votes
Easy Car Corp. is a grocery store located in the Southwest. It paid an annual dividend of $2.00 last year to its shareholders and plans to increase the dividend annually at the rate of 4.0%. It currently has 2,000,000 common shares outstanding. The shares currently sell for $13 each. Easy Car Corp. also has 30,000 semiannual bonds outstanding with a coupon rate of 10%, a maturity of 23 years, and a par value of $1,000. The bonds currently have a yield to maturity (YTM) of 8%. What is the weighted average cost of capital (WACC) for Easy Car Corp. if the corporate tax rate is 30%?

When answering this problem enter your answer using percentage notation but do not use the % symbol and use two decimals (rounding). For example, if your answer is 0.10469 then enter 10.47; if your answer is 10% then enter 10.00

Answer:_____

User EricLaw
by
7.5k points

1 Answer

3 votes

Answer:

Since the instruction in the question indicates that the % symbol should not be used, the weighted average cost of capital (WACC) for Easy Car Corp is therefore 12.07.

Explanation:

This can be calculated using the following steps:

Step 1: Calculation of the current bond price

Semiannual coupon amount = Bond face value * Semiannual coupon rate = $1000 * (10% / 2) = $50

Semiannual coupon discount factor = ((1 - (1 / (1 + r))^n) / r) .......... (1)

Where;

r = Semiannual yield to maturity (YTM) = 8% / 2 = 0.08 / 2 = 0.04

n = number of semiannuals = 23 years * 2 = 46

Substituting the values into equation (1), we have:

Semiannual coupon discount factor = ((1-(1/(1 + 0.04))^46) / 0.04) = 20.8846535613106

Present value of coupon = (Semiannual coupon amount * Semiannual coupon discount factor) = $50 * 20.8846535613106 = $1,044.23

Present value of the face value of the bond = Face value / (1 + r)^n = $1,000 / (1 + 0.04)^46 = $164.61

Therefore, we have:

Current bond price = Present value coupon + Present value of the face value of the bond = $1,044.23 + $164.61 = $1,208.84

Step 2: Calculation of weights of each finance source

Market value of common shares outstanding = Number common shares outstanding * Current price per share = 2,000,000 * $13 = $26,000,000.

Market value of bond = Number of bonds * Current bond price = 30,000 * $1,208.84 = $36,265,200

Total financing market value = Market value of common shares outstanding + Market value of bond = $26,000,000 + $36,265,200 = $62,265,200

Weight of Market value of common shares outstanding = Market value of common shares outstanding / Total financing market value = $26,000,000 / $62,265,200 = 0.42

Weight of Market value of bond = Market value of bond / Total financing market value = $36,265,200 / $62,265,200 = 0.58

Step 3: Calculation of return on equity

Current year dividend = Last year dividend * (1 + Dividend growth rate) = $2 * (1 + 4.0%) = $2.08

Next year dividend = Current year dividend * (1 + Dividend growth rate) = $2.08 * (1 + 4.0%) = $2.1632

The return on equity can now be calculated using the following formula:

Current share price = Next year dividend / (Return on equity – Dividend growth rate) ………………….. (2)

Where;

Current share price = $13

Next year dividend = $2.1632

Return on equity = ?

Dividend growth rate = 4.0%, or 0.04

Substituting the values into equation (2) and solve for return on equity, we have:

13 = 2.1632 / (Return on equity - 0.04)

13 * (Return on equity - 0.04) = 2.1632

(13 * Return on equity) – (13 * 0.04) = 2.1632

(13 * Return on equity) – 0.52 = 2.1632

13 * Return on equity = 2.1632 + 0.52

Return on equity = 2.6832 / 13

Return on equity = 0.21

Step 4: Calculation of Weighted average cost of capital

Weighted average cost of capital = (WS * CE) + (WD * CD * (1 – T)) ………………… (4)

Where;

WS = Weight of Market value of common shares outstanding = 0.42

WD = Weight of debt = Weight of Market value of bond = 0.58

CE = Cost of equity = Return on equity = 0.21

CD = Cost of debt = YTM = 8%, or 0.08

T = Tax rate = 30%, or 0.30

Substituting the values into equation (3), we have:

Weighted average cost of capital = (0.42 * 0.21) + (0.58 * 0.08 * (1 - 0.30)) = 0.12068, or 12.068%

Rounding to two decimal places, we have:

Weighted average cost of capital = 12.07%

Since the instruction in the question indicates that the % symbol should not be used, the weighted average cost of capital (WACC) for Easy Car Corp is therefore 12.07.

User Alex Fedulov
by
7.9k points
Welcome to QAmmunity.org, where you can ask questions and receive answers from other members of our community.

9.4m questions

12.2m answers

Categories