Question

ABC Inc. recently is doing the following financing: (1) The firm's non-callable bonds mature in 20 years, have an 6.5% Yield to Maturity. (2) The company’s tax rate is 40%. (3) The risk-free rate is 5%, the market return is 12%, and the stock’s beta is 1.20. (4) (4) The target capital structure has a debt to equity ratio of 1.2. The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new shares. What is its WACC?

Answer 1

Given,

Yield to maturity = 6.5%

Tax rate = 40% or 0.40

Risk free rate = 5%

Market return = 12%

Stock's beta = 1.20

Debt to equity ratio = 1.2

Solution :-

Debt = 1.2, Equity = 1

Total value = 1.2 + 1 = 2.2

Cost of common stock = Risk free rate + Stock's beta (market return - risk free rate)

= 5% + 1.20 (12% - 5%)

= 5% + 1.20 (7%)

= 5% + 8.4% = 13.4%

WACC = [cost of common stock x (equity/total value)] + [yield to maturity x (debt/total value) x (1 - tax rate)]

= [13.4% x (1/2.2)] + [6.5% x (1.2/2.2) x (1 - 0.40)]

= 6.09090909% + [6.5% x (1.2/2.2) x 0.60]

= 6.09090909% + 2.127272727% = 8.22%