Question

Question 3

XYZ is a company that does business in Brisbane. XYZ has 1 million semi-annual coupon bonds with a face value of $1000 each. At present, its bonds trade at 110% of par. The yield to maturity of the bonds is quoted at 7.5% per annum. The bonds have a coupon rate of 8.0% per annum and 15 years to maturity. The company has 150 million ordinary shares outstanding and a beta of 1.30. It currently trades at $25 per share. The market risk premium is 9.0% per annum and the risk-free rate is 4.0% per annum. XYZ is subject to 35% corporate tax rate. XYZ is planning to produce a new line of green products for Brisbane’s market. Before deciding on whether to go ahead with this potential project, the company has hired you to estimate the weighted average cost of capital (WACC) in order to evaluate the NPV analysis of this project.

1. What is the cost of equity for company XYZ?

2. What is the cost of debt for XYZ?

3. What is the after tax WACC for XYZ?

Answer 1

a. We will find this by CAPM. Re = Rf + Beta x (Rm -Rf) = 4 + 1.3 x 9=15.7%.

b. The before tax cost of debt will be the YTM of the bonds i.e. 7.5%. The after-tax cost of debt will be = 7.5 x (1-0.35) = 4.875%.

c. The debt value will be = 1000 x 1 x 1.1 = $1100 million = $1.1 billion. The equity value is = 150 x 25 = $3750 million = $3.75 billion. The WACC formula is given as:

WACC = Rd x D/(D+E) x (1-T) + Re x E/(D+E) = 7.5 x 1.1/(1.1+3.75) x 0.65 + 15.7 x 3.75/(1.1+3.75) = 13.24485%= 13.245%.