Question

A company's balance sheets show a total of $ 27 million long-term debt with a coupon rate of 12 percent. The yield to maturity on this debt is 9.07 percent, and the debt has a total current market value of $ 35 million. The balance sheets also show that that the company has 10 million shares of stock; the total of common stock and retained earnings is $30 million. The current stock price is $7.5 per share. The current return required by stockholders, r_s, is 13 percent. The company has a target capital structure of 40 percent debt and 60 percent equity. The tax rate is 40%. What weighted average cost of capital should you use to evaluate potential projects? Express your answer in percentage (without the % sign) and round it to two decimal places.

Answer 1

For the purpose of investment appraisal (evaluation of potential projects)and assuming that the company intends to closely approximate and move towards the target capital structure, one must use the target debt and equity weights. Existing or Actual debt and equity weights are used only when evaluating past performance of the firm through such measures as EVA (Economic Value Added).

Target Debt = 0.4 and Target Equity = 0.6

Cost of Equity = 13 % and Cost of Debt = Yield to Maturity of Bond = 9.07 %

Tax Rate = 40%

Target WACC = 0.4 x (1-0.4) x 9.07 + 0.6 x 13 = 9.98 % approximately.