Question

Company XYZ has a target capital structure of 20 percent debt and 80 percent equity. Its bonds

pay an average 6 percent coupon (semi-annual payout), mature in 7 years, and sell for $1049.54

per $1,000 in face value. The company stock beta is 1.02 versus the market. The risk-free rate

of interest is 4 percent and the market risk premium is 6 percent. The company is a mature,

constant growth firm that just paid a dividend (D0) of $2.57 and has a stock price (P0) of $54.00

per share. The growth rate in earnings and dividends is 5 percent while the marginal tax rate is

40 percent.

a. The after-tax cost of debt is:

b. The cost of equity using the CAPM approach is:

c. The cost of equity using the discounted cash flow approach is:

d. The weighted average cost of capital, given the target capital structure is:

Answer #1

A) To find the kd, we need to put the following values in the financial calculator :

Input | 7x2=14 | -1,049.54 | (6%/2)x1,000 =30 | 1,000 | |

Tvm | n | i/y | pv | pmt | fv |

Output | 2.57 |

Hence, kd = 2r = 2 x 2.57% = 5.15%

After-tax kd = kd x (1-t) = 5.15% x (1-0.40) = 3.09%

B). According to the CAPM,

Ke = rf + beta(mrp)

= 4% + 1.02(6%) = 4% + 6.12% = 10.12%

C). According to the Dcf,

Ke = (d1/po) + g

= {(2.57 x 1.05) / 54} + 0.05 = 0.05 + 0.05 = 0.10, or 10%

D). Average ke = (10.12% + 10%) / 2 = 10.06%

Wacc = (wd x after-tax kd) + (we x ke)

= (0.20 x 3.09%) + (0.80 x 10.06%) = 0.62% + 8.05% = 8.66%

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