Question

Assume that you have been hired as a consultant by CGT, a major producer of chemicals...

Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.

Assets

 Current assets \$38,000,000 Net plant, property, and equipment \$101,000,000 Total assets \$139,000,000

Liabilities and Equity

 Accounts payable \$10,000,000 Accruals \$9,000,000 Current liabilities \$19,000,000 Long-term debt (40,000 bonds, \$1,000 par value) \$40,000,000 Total liabilities \$59,000,000 Common stock (10,000,000 shares) \$30,000,000 Retained earnings \$50,000,000 Total shareholders' equity \$80,000,000 Total liabilities and shareholders' equity \$139,000,000

The stock is currently selling for \$17.75 per share, and its noncallable \$3,319.97 par value, 20-year, 1.70% bonds with semiannual payments are selling for \$881.00. The beta is 1.29, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.

Refer to Exhibit 10.1. What is the best estimate of the firm's WACC? Do not round your intermediate calculations.

 a. 12.11% b. 11.26% c. 12.97% d. 12.59% e. 11.74%

Rf = the yield on a 20-year Treasury bond = 5.50%

Cost of equity, Ke = Rf + Beta x (Rm - Rf) = 5.50% + 1.29 x (11.50% - 5.50%) = 13.24%

Cost of debt, Kd = YTM of the bond = 2 x semi annual yield = 2 x RATE (Nper, PMT, PV, FV) = 2 x RATE (2 x 20, 1.70% x 3319.97 / 2, -881, 3319.97) = 10.64%

market value of Debt, D = Price x Number of bonds = 881 x 40,000 = \$ 35.24 million

Market value of equity = P x N = 17.75 x 10 million = \$ 177.50 million

Wd = proporton of debt in captal structure = D / (D + E) = 35.24/(35.24 + 177.5) = 16.56%

We = proportion of equity = 1 - Wd = 1 - 16.56% = 83.44%

Tax rate, T = 40%

Hence, WACC = Wd xKd x (1 - T) + We x Ke = 16.56% x 10.64% x (1 - 40%) + 83.44% x 13.24% = 12.11%

Hence, the correct answer is the first option i.e. option a. 12.11%

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