Question

ABC company wanted to get into selling dates. It plans to develop the date manufacturing plant by using debt financing of 25% and the rest using equity. The company just issued debt at 103.4 percent of its par value, with coupon rate of 6% with 5 years maturity. It is using a comparable firms beta of 1.25. the risk-free rate is at 3 percent and the market rate is 12%. Its tax rate is at 35%. Compute what is the company weighted average cost of capital?

Answer 1

After-Tax Cost of Debt

· The Yield to maturity (YTM) of the Bond is the discount rate at which the Bond’s price equals to the present value of the coupon payments plus the present value of the Face Value/Par Value

· The Yield to maturity of (YTM) of the Bond is the estimated annual rate of return expected by the bondholders for the bond assuming that the they hold the Bonds until it’s maturity period/date.

· The Yield to maturity of (YTM) of the Bond is calculated using financial calculator as follows (Normally, the YTM is calculated either using EXCEL Functions or by using Financial Calculator)

Variables	Financial Calculator Keys	Figure
Par Value/Face Value of the Bond [$1,000]	FV	1,000
Coupon Amount [$1,000 x 6.00%]	PMT	60
Market Interest Rate or Yield to maturity on the Bond	1/Y	?
Maturity Period/Time to Maturity [5 Years]	N	5
Bond Price/Current Market Price of the Bond [-$1,000 x 103.40%]	PV	-1,034

We need to set the above figures into the financial calculator to find out the Yield to Maturity of the Bond. After entering the above keys in the financial calculator, we get the annual yield to maturity on the bond (1/Y) = 5.21%.

The firm’s after-tax cost of debt on the Bond is the after-tax Yield to maturity (YTM)

The After-tax cost of debt = Annual Yield to maturity on the bond x (1 – Tax Rate)

= 5.21% x (1 – 0.35)

= 5.21% x 0.65

= 3.39%

Cost of Equity

As per Capital Asset Pricing Model [CAPM], the cost of equity is calculated by using the following equation

Cost of equity = Risk-free Rate + Beta(Market rate – Risk free rate)

= 3.00% + 1.25(12.00% - 3.00%)

= 3.00% + [1.25 x 9.00%]

= 3.00% + 11.25%

= 14.25%

Company’s Weighted Average Cost of Capital (WACC)

Therefore, the Weighted Average Cost of Capital (WACC) = [After-tax cost debt x Weight of Debt] + [Cost of Equity x Weight of Equity]

= [3.39% x 0.25] + [14.25% x 0.75]

= 0.85% + 10.69%

= 11.54%

Hence, the Company’s Weighted Average Cost of Capital will be 11.54%