Question

Suppose a firm has 1000 5 year zero coupon bonds outstanding (par value 1000) that have a YTM of 6%. Moreover there are 500,000 shares outstanding with a Beta of 1.3. If the expected return on the market is 10% and the risk free rate is 3% (we will use CAPM even with its problems). Further assume the firm is expected to pay a 3.00 dividend and has a growth rate of 4%. Assume a 30% tax rate. What is the firm’s WACC?

Answer 1

THE WACC =

COST OF DEBT*(1- TAX RATE ) *PROPORTION OF DEBT + COST OF EQUITY * PROPORTION OF OF EQUITY

first let us calculate the cost of debt = YTM( 1 - tax rate ) = 4.2%

let us calculate the cost of equity :

using the CAPM formula :

Re = Rf + b( Rm - Rf)

= 3 + 1.3 ( 7)

= 12.1%

USING THE DDM ,

P0 = D1/ Re - G

the price per share = 3 / 0.121 - 0.04 = $37.0370 = 37.04

THERE ARE 5,00,000 SHARES OUTSTANDING , VALUE OF EQUITY IS = 18520000

the value of bonds is 1000/1.06 ^5 the present value of bond disounted 5 years back we get,

PV = $747.26 there are 1000 bonds so the present value is = $747260

TOTAL VALUE = 19267260

PROPORTION OF DEBT = 0.0388

PROPRTION OF EQUITY = 0.9612

WACC = 0.0388 * 0.042 + 0.9612 * 0.121

= 0.0016 + 0.1163

= 11.79 %

THEREFORE, THE WACC OF THE FIRM IS 11.79%