Question

Epson has one bond outstanding with a yield to maturity of 7% and a coupon rate of 8%. The company has no preferred stock. Epson's beta is 1.3, the risk-free rate is 0.5% and the expected market risk premium is 6%.

Epson has a target debt/equity ratio of 0.7 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, i.e., the fraction of long-term capital provided by equity?

What is Epson's weighted average cost of capital?

Answer 1

1) Pre - Tax Cost of Debt = YTM of outstanding bond
Pre - Tax Cost of Debt = 7%

2) Cost of Equity = Risk-free rate + (Beta * Expected Market Risk Premium)
= 0.5% + (1.3 * 6%)
= 0.5% + 7.8%
Cost of Equity = 8.3%

3) Debt/Equity Ratio = 0.7/1
Total Capital = Debt + equity
= 0.7 + 1
Total Capital = 1.7

Equity portion = Equity / Total Capital
= 1 / 1.7
Weightage of Equity or Equity portion =  0.5882 or 58.82%

4) Weightage of Debt = 1 - Weightage of Equity = 1 - 0.5882 = 0.4118
WACC = Weighted Average Cost of Capital

WACC = [Cost of debt * (1 - Tax Rate) * Weightage of debt] + (Cost of Equity * Weightage of Equity)
= [7% * (1-0.34) * 41.18%] + (8.3% * 58.82%)
= 1.902516% + 4.88206%
WACC = 6.784576% ~ 6.78%