Question

WACC Comparables - 2

If it were unlevered, the overall firm beta for Wild Widgets Inc. (WWI) would be 1.6. WWI has a target debt/equity ratio of 1. The expected return on the market is 0.11, and Treasury bills are currently selling to yield 0.05. WWI one-year bonds (with a face value of $1,000) carry an annual coupon of 12% and are selling for $944.08. The corporate tax rate is 35%.(Round your answers to 2 decimal places before the percentage sign. (e.g., 10.23%))

a. WWI’s before-tax cost of debt is ____%.

b. WWI’s cost of equity is ______%.

c. WWI’s weighted average cost of capital is _____%.

Answer 1

(a) Bond Tenure = 1 year, Face Value = $ 1000, Annual Coupon = 12 % and Current Price = $ 944.08

Annual Coupon Payment = 0.12 x 1000 = $ 120

Let the Yield to Maturity be R

Therefore, 944.08 = [1000 + 120] / (1+R)

R = [1120 / 944.08] - 1 = 18.63 %

Before-Tax Cost of Debt = Yield to Maturity = 18.63 %

(b) Treasury Bill Rate = Risk-Free Rate = 0.05 or 5 % and Market Return = 0.11 or 11 %

Unlevered Beta = 1.6 and Debt to Equity Ratio = DE = 1

Tax Rate = 35 %

Levered Beta = Bl = 1.6 x [1+(1) x (1-0.35)] = 2.64

Cost of Equity = 5 + 2.64 x (11 - 5) = 20.84%

(c) Debt to Value Ratio = 0.5 and Equity to Value Ratio = 0.5 (Value = Debt + Equity and Debt = Equity as DE = 1)

Weighted Average Cost of Capital = (1-0.35) x 18.63 x 0.5 + 20.84 x 0.5 = 16.47475 % ~ 16.475 %