Question

Williams construction:

Debt: 12,000 bonds and each sells for $100, with 12 % YTM. The company is in the 30% tax bracket.

Common Equity: 15,000 shares of common stock outstanding, sells for $40/share. The stock's beta is 0.80. The risk-free rate is 2% and the market return is 8%.

1. Based on above, the before-tax cost of debt for Williams Construction is ________. In the 30% tax bracket, then the after-tax cost of debt is _________.

2. CAPM tells you that the cost of equity is ______

3. The capital structure weight is _______ for debt and ______ for common stocks.

4. The WACC (cost of capital) for Williams Construction is ________

Answer 1

1.

Before tax cost of debt for Williams construction is 12%

After tax cost of debt = 12% * (1-30%) = 8.40%

2.

Rf = Risk free rate = 2%

Rm = Market return = 8%

Beta = 0.80

According to CAPM, Cost of equity can be calculated using the below formula

Cost of equity = Rf + beta * (Rm - Rf)

= 2% + 0.80* (8%-2%)

= 2% +4.8%

= 6.8%

Cost of Equity using CAPM is 6.8%

3.

Md= Market Value of Debt = 12,000 * $100 = $1,200,000

Me = Market Value of Equity = 15,000 * $40 = $600,000

Wd = Weight of Debt = Md / (Md + Me) = $1,200,000 / ($1,200,000 + $600,000) = 0.6666667

We = Weight of Equity = Me / (Md + Me) = $600,000 / ($1,200,000 + $600,000) = 0.3333333

4.

WACC = [Wd * after tax cost of debt] + [We * Cost of equity]

= [0.6666667 * 8.40%] + [0.3333333 * 6.80%]

= 5.6% + 2.266666644%

= 7.86666644%

Therefore, WACC (Cost of capital) for Willian Construction is 7.87%