Question

You are asked to calculate the weighted average cost of capital for Meritel Inc, a telecom firm. The risk free rate is currently 4%, the expected market return is 11%, and Meritel’s beta is 1.8. They have one piece of long term debt on their balance sheet – a zero coupon bond maturing in ten years. The $1000 par value bond currently trades at $558.40 in the market. The tax rate is 35% and Meritel capital structure is 50% debt and 50% equity. What are Meritel’s:

a) Cost of equity

b) Cost of debt

c) WACC?

Answer 1

Rf = 4%

Erm= 11%

Meritel's Beta = 1.8

a) Meritel's Cost of Equity :

=

=14.8%

b) Meritel's Cost of Debt :

For this, we will first calculate Yeild to maturity

YTM = (Face value / Current bond price)^ (1/Time to maturity) - 1

= 1000/558.40 ^(1/10) - 1

= .0599= 5.99%

Cost of Debt = (YTM)(1-t)

= .0599(1-.35)

=.0599(.65)

= 3.8935%

** Here yeild to maturity is calculated because zero coupon bond does not fetch any interest payment and hence it is the total return anticipated on bond until it's maturity.

c) WACC = [Total cost of equity * % of equity + Total cost od debt * % of debt]

= 14.8% *.50 + 3.8935%*.50

=9.346%