Question

Gateway Services' CFO is interested in estimating the company's WACC and has collected the following information: · The company has 30-year, 7.5% annual coupon bonds that have a face value of $1,000 and sell for $1105. · The risk-free rate is 2.5%. · The expected return on the market is 8%. · The stock's beta is 1.8. · The company's tax rate is 25%. · The company's target capital structure consists of 70% equity and 30% debt. · \What is Gateway's WACC?

Answer 1

Debt:

Face Value = $1,000
Current Price = $1,105

Annual Coupon Rate = 7.50%
Annual Coupon = 7.50% * $1,000
Annual Coupon = $75

Time to Maturity = 30 years

Let Annual YTM be i%

$1,105 = $75 * PVIFA(i%, 30) + $1,000 * PVIF(i%, 30)

Using financial calculator:
N = 30
PV = -1105
PMT = 75
FV = 1000

I = 6.68%

Annual YTM = 6.68%

Before-tax Cost of Debt = 6.68%
After-tax Cost of Debt = 6.68% * (1 - 0.25)
After-tax Cost of Debt = 5.01%

Equity:

Cost of Equity = Risk-free Rate + Beta * (Market Return - Risk-free Rate)
Cost of Equity = 2.50% + 1.80 * (8.00% - 2.50)
Cost of Equity = 2.50% + 1.80 * 5.50%
Cost of Equity = 12.40%

WACC = Weight of Debt * After-tax Cost of Debt + Weight of Equity * Cost of Equity
WACC = 0.30 * 5.01% + 0.70 * 12.40%
WACC = 10.18%