Question

Consider the following information concerning Pacific Stars Inc.'s capital structure:

- The company has 80,000 shares of common stock outstanding at a current market price of $20 per share. The stock has s beta of 1.2. The market risk premium is 6% and the risk-free rate is 3%.

- The company has 2,000 bonds outstanding, with 6% coupon and 20 years to maturity. The bond is currently selling for $1,103.8, with a yield-to-maturity of 5%.

- The tax rate for the company is 20%.

(a) What is the cost of equity for Pacific Stars?

(b) What is the weighted average cost of capital (WACC) for Pacific Stars?

show your workings

Answer 1

(a) Computation of cost of equity

As per CAPM model, the cost of equity can be computed as follows:

Cost of equity = Risk free rate + Beta * Market risk premium

= 3% + 1.2 * 6%

= 10.2%

(b) Computation of weighted average cost of capital

After tax cost of debt = YTM (1- tax)

= 5% (1-0.2)

= 4%

Market value of stock = 80,000 shares * $20 = $1,600,000

Market value of bonds = 2,000 bonds * $1,103.8 = $ 2,207,600

Particulars	Amount	Weights (A)	Rate of return (B)	Weighted Avg. cost of capital (A)*(B)
Equity	1,600,000	0.42	10.20%	4.3%
Debt	2,207,600	0.58	4%	2.3%
	3,807,600			6.6%