Question

# You have been asked by JJ Corporation to estimate its cost of capital. It currently has...

You have been asked by JJ Corporation to estimate its cost of capital. It currently has 9.1 million shares, \$0.1 par value, outstanding trading at \$10 per share. In addition, it has 50,000 bonds with a coupon rate of 8% trading at 98% of face value of \$1000. The bonds yield a rate of return of 9%. The beta for equity is 1.2. The risk-free rate is 2.5%. The current market risk premium is 5%. The tax rate is 25%.

1. What is the firm’s current debt-equity ratio?
2. What is the firm’s current weighted average cost of capital?

Solution :-

Market Value of Shares = 9,100,000 * \$10 = \$91,000,000

Market Value of Bonds = 50,000 * \$1000 * 98% = \$49,000,000

Now total Debt and Equity = \$91,000,000 + \$49,000,000 = \$140,000,000

(A)

Now Debt Equity Ratio = ( Debt / Equity ) = \$49,000,000 / \$91,000,000 = 0.5385

Debt Equity Ratio = 0.5385 : 1

(B)

Weight of Debt = Debt / Total value = \$49,000,000 / \$140,000,000 = 0.35

Weight of Equity = 1 - 0.35 = 0.65

Now Cost of Equity = Rf + Beta * Risk Premium = 2.5% + 1.2 * 5% = 8.5%

After tax Cost of Debt = Kd * ( 1 - tax ) = 9% * ( 1 - 0.25 ) = 6.75%

Now WACC = ( Wd * After tax Kd ) + ( We * Ke )

= ( 0.35 * 6.75% ) + ( 0.65 * 8.5% )

= 7.89%

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