Question

Daves Inc. recently hired you as a consultant to estimate the company’s WACC. You have obtained the following information. (1) The firm's bonds have a YTM of 6%. (2) The company’s tax rate is 30%. (3) The risk-free rate is 4%, the market risk premium is 5%, and the stock’s beta is 1.10. (4) The target capital structure consists of 30% debt and the balance is common equity. 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?Daves Inc. recently hired you as a consultant to estimate the company’s WACC. You have obtained the following information. (1) The firm's bonds have a YTM of 6%. (2) The company’s tax rate is 30%. (3) The risk-free rate is 4%, the market risk premium is 5%, and the stock’s beta is 1.10. (4) The target capital structure consists of 30% debt and the balance is common equity. 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 = 7.91%

Calculation :-

Step 1 - Calculate Cost of Debt & Equity :-

Cost of Debt = YTM (1 - Tax rate)

Cost of Debt = 6 (1 - 0.30)

Cost of Debt = 4.20%

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

Cost of Equity = 4 + (5 x 1.10)

Cost of Equity = 9.50%

Step 2 - Calculate WACC as per target capital structure :-

Debt target = 30%(As per question)

Equity target = 70%(Balance)

Therefore;

WACC = (Cost of Debt x Debt target) + (Cost of Equity x Equity target)

WACC = (4.20 x 30%) + (9.50 x 70%)

WACC = 1.26% + 6.65%

WACC = 7.91%

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