Question

Assume that the current stock price of a company is $20 per share. The company has 500,000 outstanding shares and a beta of 1.2. The expected market risk premium is 4% and the risk-free rate of return is 7%. If the current market value of the company's debt is $6,000,000 with an after-tax cost of 9%, the company's weighted average cost of capital (WACC) for a 20% tax rate is closest to:

Select one:

a. 11.43%

b. 11.80%

c. 10.08%

d. 10.75%

Answer 1

Given about a company,

current stock price = $20

outstanding shares = 500000

So, current market value of equity = stock price*shares = 20*500000 = $10000000

beta of stock = 1.2

Risk free rate Rf = 7%

Market risk premium MRP = 4%

So, cost of equity of stock using CAPM is Rf + beta*MRP

=> cost of equity of company, Ke = 7 + 1.2*4 = 11.80%

Market value of Debt = $6000000

after-tax cost of debt Kd*(1-T) = 9%

So, weight of debt Wd = MV of debt/(MV of debt + MV of equity) = 6000000/(6000000 + 10000000) = 0.375

Similarly weight of equity We = 1- Wd = 1 - 0.375 = 0.625

Tax rate T = 20%

company's weighted average cost of capital = Wd*Kd*(1-T) + We*Ke = 0.375*9 + 0.625*11.80 = 10.75%

Option d is correct.