Question

1. Firm Z has outstanding bonds with a 5% coupon that mature in 10 years and are currently selling for $975.    The firm’s managers believe that they can raise new debt at a similar rate. The firm’s tax-rate is 30%. Also, the firm’s beta is 1.5, the market risk premium is 6% and the risk-free rate is 3%. If the firm’s target capital structure is evenly split between debt and common equity but no preferred stock, what is the firm’s weighted average cost of capital (wacc)?

Answer 1

Weighted Average Cost of Capital (WACC)

Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of equity x Weight of Equity]

After-tax Cost of Debt

Face Value = $1,000

Bond Price = $975

Annual Coupon Amount = $50 [$1,000 x 5%]

Maturity Period = 10 Years

Yield To Maturity [YTM] = Coupon Amount + [(Face Value – Bond Price) / Maturity Years] / [(Face Value + Bond Price)/2]

= $50 + [($1,000 – 975) / 10)] / [($1,000 + 975) / 2]

= [($50 + $2.50) / $987.50]

= [$52.50 / $987.50]

= 0.0533

= 5.33%

After Tax Cost of Debt = Yield to maturity x (1 – Tax Rate)

= 5.33% x [1 – 0.30]

= 5.33% x 0.70

= 3.73%

Cost of Equity

Cost of Equity = Risk-free Rate + (Beta x Market Risk Premium)

= 3% + (1.5 x 6%)

= 3% + 9%

= 12%

Weighted Average Cost of Capital (WACC)

Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of equity x Weight of Equity]

= (3.73% x 0.50) + (12% x 0.50)

= 1.87% + 6%

= 7.87%

“Therefore, the firm’s weighted average cost of capital (WACC) would be 7.87%”