Question

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%.

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

Answer #1

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%

If there is any doubt please ask in comments

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