Question

Jack's Construction Co. has 80 bonds outstanding that are selling at their par value of $1,000 each. Bonds with similar characteristics are yielding a pretax 8.6 percent. The firm also has 4,000 shares of common stock outstanding. The stock has a beta of 1.1 and sells for $40 a share. The U.S. T-bill is yielding 4 percent, the market risk premium is 8 percent, and the firm's tax rate is 21 percent. What is the firm's weighted average cost of capital assuming its earnings are sufficient to classify all interest as a tax-deductible expense? What does this WACC mean?

Answer 1

Market Value of Debt and Equity

Market Value of Debt = $80,000 [80 Bonds x $1,000 per bond]

Market Value of Equity = $160,000 [4,000 Shares x $40 per share]

Total Market Value = $240,000 [$80,000 + $160,000]

Weight of Capital Structure

Weight of Debt = 0.3333 [$80,000 / $240,000]

Weight of Equity = 0.6667 [$160,000 / $240,000]

After Tax Cost of Debt

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

= 8.60% x (1 – 0.21)

= 8.60% x 0.79

= 6.79%

Cost of Equity

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

= 4.00% + (1.10 x 8.00%)

= 4.00% + 8.80%

= 12.80%

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

= (6.79% x 0.3333) + (12.80% x 0.6667)

= 2.27% + 8.53%

= 10.80%

“Hence, the firm's weighted average cost of capital would be 10.80%”