Question

Firm Why has a capital structure based on market values of 40 percent debt and the...

Firm Why has a capital structure based on market values of 40 percent debt and the rest common equity. You know that the coupon rate on the debt is 8 percent and the yield to maturity on the debt is 9.3 percent. You also know that the common equity beta is 1.54, the market risk premium is 5.5 percent and the risk-free rate is 2 percent, and the tax rate is 40 percent. Find Firm Why's WACC. Input your answer as a decimal rounded to four places.

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Answer #1

Debt % (of total capital) = 40%, Equity % (of total capital) = 60%.

Cost of Equity (by CAPM) = Rf + (B * Rp); where Rf is risk free rate (2%), Beta (B) is 1.54, Rp is Market Risk premium which is 5.5% here. Hence Cost of Equity in this question = 2% + (1.54 * 5.5%) = 10.47%

Cost of Debt is calculated using YTM (and not coupon rate).

Post tax cost of debt = Pretax Cost of Debt * (1 - tax Rate) = 9.3% * (1 - 40%) = 5.58%

WACC = weighted average (post tax) cost of debt and cost of equity.

= (40% * 5.58%) + (60% * 10.47%) = 8.51%

  

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