Question

Campbell's kitchen (CK)’s stock currently is selling for $50 per share. Last dividends paid by CK were $2.00 per share. CK is expected to grow at an 8 percent constant rate forever. The risk-free rate is 4 percent, market risk premium is 6.6 percent, and CK’s beta is 1.25. CK bonds are matured in 25 years with 8 percent coupon rate. The par value of bonds is $1000, and the interest payments are made annually. The bonds are currently selling for $960 per bond. CK’s target capital structure is 40% debt and 60% common equity. CK’s tax rate is 40%

a) What is the firm’s before-tax cost of debt, b) what is the firm’s after-tax cost of debt, c) What is firm’s cost of common equity using CAPM approach, d) What is firm’s cost of common equity using discounted cash flow approach, and e) what is firm’s WACC using CAPM approach (Please provide step by step detail)

Answer 1

a)

To find the before-tax cost of debt we will calculate YTM with the help of BA 2 plus financial calculator-

N(years to maturity) = 25

PMT(Coupon) = 80

FV(par value) = 1000

PV(Price) = 960

CMPT I/Y

YTM = 8.38%

The before-tax cost of debt = 8.38%

b)

The after-tax cost of debt = before-tax cost of debt*(1-tax rate)

= 8.38%*(1-0.4)

= 5.028%

c)

cost of equity using CAPM approach = Risk free rate + (Beta*(market risk premium)

= 4% + (1.25*6.6%)

= 12.25%

d)

cost of common equity using discounted cash flow:

D1 = D0*(1+g) = $2*(1.08) = $2.16

Price = D1/(cost of equity-growth rate)

cost of equity- 8% = $2.16/ $50

cost of equity = 12.32%

e)

WACC = (weight of debt*after-tax cost of debt) + (weight of equity*after-tax cost of equity using CAPM)

= (0.4*5.028%) + (0.6*12.25%)

= 2.0112% + 7.35%

= 9.3612%