Question

Epson has one bond outstanding with a yield to maturity of 6% and a coupon rate of 8%. The company has no preferred stock. Epson's beta is 0.6, the risk-free rate is 3.3% and the expected market risk premium is 6%.

Epson has a target debt/equity ratio of 0.6 and a marginal tax rate of 34%.
What is Epson's (pre-tax) cost of debt?
What is Epson's cost of equity?
What is Epson's capital structure weight for equity?
What is Epson's WACC?

Answer 1

What is Epson's (pre-tax) cost of debt?

Yield to maturity = 6%

Hence, Pre-tax cost of debt = 6%

.

What is Epson's cost of equity?

As per CAPM equation:

Cost of equity = Risk free rate + Beta x Market risk premium

Cost of equity = 3.3% + 0.6*6%

Cost of equity = 6.90%

.

What is Epson's capital structure weight for equity?

Weight of equity = 1/(debt equity ratio + 1) = 1/1.6 = 62.50%

Therefore, Weight of debt = 1-Weight of equity = 0.6/1.6 = 37.50%

What is Epson's WACC?

.

WACC = Cost of equity x Weight of equity + Pre-tax cost of debt x Weight of debt x (1-tax rate)

WACC = 6.90% x 1/1.6 + 6% x 0.6/1.6 x (1-34%)

WACC = 5.80%

(Calculated WACC based on post tax debt cost)