Question

If Wild Widgets, Inc., were an all-equity company, it would have a beta of 1.15. The company has a target debt–equity ratio of .6. The expected return on the market portfolio is 10 percent, and Treasury bills currently yield 3.6 percent. The company has one bond issue outstanding that matures in 20 years and has a coupon rate of 8.2 percent. The bond currently sells for $1,140. The corporate tax rate is 35 percent. a. What is the company’s cost of debt? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) % b. What is the company’s cost of equity? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Cost of equity % c. What is the company’s weighted average cost of capital? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) WACC %

Answer 1

Solution :

Face Value of Bond = 1000, Coupon = 8.2% = 1000 *8.2%= 82, Time = 20 years , Current Price = 1140

In order to find cost of debt , we have to find the yield of the bond

Yield = 7.01%

After tax cost of debt = 7.01% * ( 1-0.35 ) = 4.556%

Part B ) In order to find cost of equity we can use CAPM model

Rf = 3.6% , Market Return = 10% , Beta = 1.15

Cost of equity = Rf + beta * ( Rm -Rf) = 3.6% + 1.15 * ( 10% -3.6% ) = 3.6% + 7.36% = 10.96%

Part C ) Debt / Equity = 0.6 , Debt / Equity + 1 = 0.6 + 1 = 1.6, (Debt + Equity) / Equity = 1.6

Equity / ( Debt +Equity) = 1 / 1.6 = 0.625

Equity weightage = 0.625, Debt weightage = 0.375

WACC = Cost of equity * Weight of equity + Cost of debt * weight of debt

WACC = 10.96% * 0.625 + 4.556% * 0.375 = 8.56%