Question

Suppose a company has 100 million common shares outstanding, and each share sells for $20. We have estimated that the shares have a beta of 1.25, the risk-free rate is 2%, and the expected market return is 6%. The marginal tax rate for this company is 35%. The company also has $1 billion of bonds outstanding and the yield to maturity on these bonds is 4%. The company has a target capital structure of 60% equity and 40% debt. It does not and will not issue preferred stocks in the future. What is the WACC for this company? What is the after-tax cost of debt for this company?

Answer 1

Value of Share = 100 million share * $ 20 = $ 2,000 million

Beta of Share = 1.25 ; Risk Free rate = 2% ; Return from Market = 6% ; Tax rate = 35%

Value of Bonds = $1 billion

YTM on Bonds = 4%

Weight of equity = 0.6 and weight of debt = 0.4

Using Capital Asset Pricing Model,

Cost of Equity (Ke) = Risk Free Rate + Beta ( Return from Market - Risk Free rate )

= 2 + 1.25 (6-2) = 7%

Cost of Debt (Kd) = YTM ( 1-tax rate ) = 4( 1-35%) = 2.6%

WACC = Weight of equity * Ke + Weight of debt * Kd = 0.6 * 7 + 0.4 * 2.6 = 5.24%

After tax Cost of debt (Kd) = 2.6%