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 noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,000.00. (2) The company's tax rate is 25%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock's beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of equity, and it does not expect to issue any new common stock. What is its WACC? Do not round your intermediate calculations.

a. 11.03%

b. 9.32%

c. 6.76%

d. 8.90%

e. 10.32%

Answer 1

Cost of Equity = Risk Free Rate + Beta*(Market Risk Premium)
= 4.50% + 1.20 (5.50%)
=4.50% + 6.60%
=11.10%

Cost of Debt after Tax = k_d

Here,
I = Interest paid per bond
t = tax rate in decimal form
P₀ = Market Price of bond

OR

We have Cost of Debt = 6%
Weight of Debt in Capital structure = 35%

Cost of Equity = 11.10%
Weight of Equity in Capital structure = 100% - 35% = 65%

Formula for WACC:

Here k_d is after tax cost of debt.

Therefore,