Question

Daves Inc. recently hired you as a consultant to estimate the company’s WACC. You have obtained the following information. (1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,075.00. (2) The company’s tax rate is 40%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock’s beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of equity, and it does not expect to issue any new common stock. What is its WACC?

8.74%

7.52%

8.13%

9.53%

9.18%

Answer 1

Debt:

Face Value = $1,000
Current Price = $1,075
Annual Coupon = 8%*$1,000 = $80
Time to Maturity = 20 years

Let Annual YTM be i%

$1,075 = $80 * PVIFA(i%, 20) + $1,000 * PVIF(i%, 20)

Using financial calculator:
N = 20
PV = -1075
PMT = 80
FV = 1000

I/Y = 7.28%

Before-tax Cost of Debt = 7.28%
After-tax Cost of Debt = 7.28%*(1-0.40)
After-tax Cost of Debt = 4.368%

Equity:

Risk-free Rate = 4.50%
Market Risk Premium = 5.50%
beta = 1.20

Cost of Equity = Risk-free Rate + beta * Market Risk Premium
Cost of Equity = 4.50% + 1.20 * 5.50%
Cost of Equity = 11.10%

WACC = Weight of Debt * After-tax Cost of Debt + Weight of Equity * Cost of Equity
WACC = 35% * 4.368% + 65% * 11.10%
WACC = 8.74%