Question

You are the CFO of a company, and you need to analyze a new product line. The company has 10% coupon-bonds outstanding with $1000 face value that trade at par. Their stock, which trades at $50 on the NASDAQ has a beta of 1.25, plans to pay a dividend of $3.00 in one year, and the dividends are expected to grow at 5% annually, indefinitely. The company has a debt-to-equity ratio of 7 and pays taxes at the 35% annual tax rate. If the expected return on the market is 8% and treasury bills pay 4%, what is the weighted average cost of capital for FIN317 Corp? (assume no preferred stock)

Answer 1

WACC = (weight of debt * cost of debt) + (weight of equity * cost of equity)

weight of debt = debt / (debt + equity) = 7 / (7 + 1) = 0.875

weight of debt = equity / (debt + equity) = 1 / (7 + 1) = 0.125

cost of debt = YTM of bonds * (1 - tax rate)

As the bonds are trading at their par value, their YTM equals their coupon rate.

cost of debt = 10% * (1 - 35%) = 6.50%

cost of equity (CAPM) = risk free rate + (beta * (market return - risk free rate))

cost of equity (CAPM) = 4% + (1.25 * (8% - 4%)) ==> 9.00%

cost of equity (dividend growth model) = (next year dividend / current share price) + constant growth rate

cost of equity (dividend growth model) = ($3 / $50) + 5% = 11.00%

cost of equity = average of two methods = (9.00% + 11.00%) / 2 = 10.00%

WACC = (weight of debt * cost of debt) + (weight of equity * cost of equity)

WACC = (0.875 * 6.50%) + (0.125 * 10.00%)

WACC = 6.9375%