Question

Consider the following information concerning Pacific Stars Inc.’s capital structure:

• The company has 80,000 shares of common stock outstanding at a current market price of $20 per share. The stock has a beta of 1.2. The market risk premium is 6% and the risk-free rate is 3%.
• The company has 2,000 bonds outstanding, with 6% coupon and 20 years to maturity. The bond is currently selling for $1,103.8, with a yield-to-maturity of 5%.
• The tax rate for the company is 20%

(a) What is the cost of equity for Pacific Stars? [5 points]

(b) What is the weighted average cost of capital (WACC) for Pacific Stars? [10 points]

Answer 1

1.Cost of equity=risk free rate+(beta*market risk premium)

Cost of equity=3%+(1.2*6%)=10.2%

2.Before tax cost of debt=5% (which is the yield to maturity)

After tax cost of debt=Before tax cost of debt*(1-tax rate)=5%*(1-20%)=4%

Market value of the equity=Shares outstanding*market price=80,000*20=1,600,000

Market value of the debt=bonds outstanding*current price=2000*1103.8=2,207,600

Total value=1600000+2207600=3807600

weight of equity=1600000/3807600=42.0%

Weight of debt=2207600/3807600=58.0%

WACC=(weight of debt*after tax cost of debt)+(weight of equity*cost of equity)

WACC=(58%*4%)+(42%*10.2%)=6.61%