Question

ABC Inc. recently is doing the following financing: (1) The firm's non-callable bonds mature in 20 years, have an 7.00% Yield to Maturity. (2) The company’s tax rate is 35%. (3) The risk-free rate is 3.5%, the market return is 12%, and the stock’s beta is 1.10. (4) The target capital structure has a debt to equity ratio of 1.8. The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new shares. What is its WACC?

Answer 1

WACC = 7.514%

Calculation :-

Step 1 - Calculate Weight of debt & Equity :-

Target debt to equity ratio = 1.8

that means for equity of 1 debt should be 1.8,

total capital = debt + equity,

Hence target capital structure is 1.8 + 1 = 2.8

Therefore ;

weight of debt = (1.8 / 2.8) x 100

weight of debt = 64.2857%

weight of equity = (1 / 2.8) x 100

weight of equity = 35.7143%

Step 2 - Calculate Cost of Debt & Equity :-

Cost of Debt = Yield to Maturity ( 1 - tax rate)

Cost of Debt = 7 (1 - 0.35)

Cost of Debt = 4.55%

Cost of Equity = risk-free rate + (market return -  risk-free rate) x Beta

Cost of Equity = 3.5 + (12 - 3.5) x 1.10

Cost of Equity = 3.5 + 9.35

Cost of Equity = 12.85%

Step 3 - Calculate WACC :-

WACC = (Cost of Debt x weight of debt) + (Cost of Equity x weight of equity)

WACC = (4.55 x 64.2857%) + (12.85 x 35.7143%)

WACC = 2.9250 + 4.5893

WACC = 7.514%