Question

Jeff recently hired you as a consultant to estimate the company’s WACC. You have obtained the following information. (1) JB's bonds mature in 25 years, have a 7.5% annual coupon, a par value of $1,000, and a market price of $936.49. (2) The company’s tax rate is 40%. (3) The risk-free rate is 6.0%, the market risk premium is 5.0%, and the stock’s beta is 1.5. (4) The target capital structure consists of 30% debt and 70% equity. JB uses the CAPM to estimate the cost of equity, and it does not expect to have to issue any new common stock. What is its WACC?

a) 10.64%

b) 10.35%

c) 9.89%

d) 10.91%

Answer 1

Answer:
Debt:
Face Value = $1,000
Current Price = $936.49

Annual Coupon Rate = 7.5%
Annual Coupon = 7.50% * $1,000 = $75

Time to Maturity = 25 years

Let Annual YTM be i%

$936.49 = $75 * PVIFA(i%, 25) + $1,000 * PVIF(i%, 25)

Using financial calculator:
N = 25
PV = -936.49
PMT = 75
FV = 1000

I = 8.10%

Annual YTM = 8.10%

Before-tax Cost of Debt = 8.10%
After-tax Cost of Debt = 8.10% * (1 - 0.40)
After-tax Cost of Debt = 4.86%

Equity:
Cost of Equity = Risk-free Rate + Beta * Market Risk Premium
Cost of Equity = 6.0% + 1.5 * 5.0%
Cost of Equity = 13.50%

Weight of Debt = 0.30
Weight of Equity = 0.70

WACC = (Weight of Debt*After-tax Cost of Debt) + (Weight of Equity *Cost of Equity)
WACC = (0.30 * 4.86%) + (0.70 * 13.50%)
WACC = 10.91%

Option d is Correct.