Question

The XXX Company has a marginal tax rate of 40%. The company can issue new bonds at par that would provide a 8.5% YTM. The firm’s beta is 0.7, the T-bill rate is 5%, and the market return is 12%. The firm’s long-term debt currently sells at par value for $3,000. The firm has 700 shares of common stock outstanding that sell for $10 per share. What is XXX’s capital structure based on market weights?

a. 60% in debt, 40% in equity.

b. 50% in debt, 50% in equity.

c. 30% in debt, 70% in equity.

d. 75% in debt, 25% in equity.

e. 40% in debt, 60% in equity.

What is the firm's weighted average cost of capital?

Select one:

a. 7.20%

b. 5.70%

c. 5.59%

d. 8.46%

e. 6.30%

Answer 1

Cost of common Equity = Risk free rate + [beta * (Market return - risk free rate)]

Cost of common Equity = 5% + [0.7 * (12% - 5%)] = 9.90%

Cost of Debt = YTM of bond = 8.50%

Total value of Equity = 700 * $10 = $7,000

Total value of debt (bonds) = $3,000

Total value = $3,000 + $7,000 = $10,000

Weight of Equity = $7,000/ $10,000 = 70%

Weight of Debt = $3,000/ $10,000 = 30%

WACC = [(0.70 * 9.90%) + (0.30 * 8.50 * (1-0.40)] = 8.46%

So,

Capital structure based on market weights = 30% of Debt and 70% of Equity

WACC = 8.46%