Question

Wonderful Ltd currently has 1.2 million ordinary shares outstanding and the share has a beta of 2.2. It also has $10 million face value of bonds that have 5 years remaining to maturity and 8% coupon rate with semi-annual payments, and are priced to yield 13.65%. If Wonderful issues up to $2.5 million of new bonds, the bonds will be priced at par and have a yield of 13.65%; if it issues bonds beyond $2.5 million, the expected yield on the entire issuance will be 16%. Wonderful has learned that it can issue new ordinary shares at $10 a share. The current risk-free rate of interest is 3% and the expected market return is 10%. Wonderful's marginal tax rate is 30%. Compute the market value for both bond and equity.

If Wonderful intends to raise $7.5 million of new capital while maintaining the same debt-to-equity ratio as above, compute its weighted average cost of capital (WACC).

Can Wonderful Ltduse the WACC computed for all of its future investment projects? Why?

Answer 1

Cost of equity (as per CAPM) = 3%+2.2*(10%-3%) = 18.40%

Market Value of equity = $10 /share * 1.2 million shares = $12 million

Semi annual coupon = $10 million * 8%/2 = $0.4 million

Semiannaul yield = 13.65%/2 =0.06825

Market value of bonds ($ million) = 0.4/0.06825*(1-1/1.06825^10)+10/1.06825^10 = 7.999688 million or $8 million

So, weight of Debt = 8/(8+12) = 40%

and weight of Equity = 12/(8+12) = 60%

Cost of Debt for the issuance = 16% (as the issue is above $2.5 million)

So, WACC = 40%*16%*(1-0.3) + 60%*18.40%

=15.52%

Wonderful Ltd cannot use the WACC computed for all of its future investment projects. Even if the company maintains a constant Debt: Equity ratio,  because

1) The project specific cost of debt may change.

2) The project may be more riskier so, the cost of equity has to be appropriately taken

3) The marginal tax rate may change.