Question

A firm has a corporate bond traded in the secondary market. The maturity of this bond is 5 years and annual coupon interest rate is 12.5%. The bond pays annual coupons and par value is 100$. The market price of this bond is 94.5$. The expected dividend for the next year is 0.75$ per share and the market price of one share is 12$. The corporate tax rate is 20%, the beta of the firm is 1.1, the risk free rate is 9%, and the market risk premium is 6%. The firm targets a debt/equity ratio of 0.5. Estimate the approximate WACC for this firm.

Answer 1

D/A = D/(E+D)

D/A = 0.5/(1+0.5)

=0.3333

Weight of equity = 1-D/A

Weight of equity = 1-0.3333

W(E)=0.6667

Weight of debt = D/A

Weight of debt = 0.3333

W(D)=0.3333

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (Market risk premium)

Cost of equity% = 9 + 1.1 * (6)

Cost of equity% = 15.6

Cost of debt

K = N

Bond Price =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =5

94.5 =∑ [(12.5*100/100)/(1 + YTM/100)^k]     +   100/(1 + YTM/100)^5

k=1

YTM = 14.106148587

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 14.106148587*(1-0.2)

= 11.2849188696

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=11.28*0.3333+15.6*0.6667

WACC =14.16%