Question

A firm is 65% equity and 35% debt. The firm's marginal tax rate is 40%. Their bonds trade for $990, mature in nine years, have a par value of $1,000, a coupon rate of 8.00% and pay semi-annually. The firm's common stock trades for $27 and just paid a dividend of $5.00. Dividends are expected to grow at 3% forever. The firm's WACC is ___%.

PELASE USE FINNACE CALUATOR OR USE BAISC CALUTOR WITH SOULTIONS

Answer 1

Information provided:

Proportion invested in debt= 35%

Proportion invested in equity= 65%

Par value= future value= $1,000

Current price= present value= $990

Coupon rate= 8%/2= 4%

Coupon payment= 0.04*1,000= $40

Time= 9 years*2=18 semi-annual periods

Tax rate= 40%

Priec of common stock= $27

Current dividend= $5

Dividend growth rate= 3%

The question is solved by first calculating the before tax cost of debt which is the yield to maturity.

Enter the below in a financial calculator to compute the yield to maturity:

FV= 1,000

PV= -990

PMT= 40

N= 18

The value obtained is 4.0795%.

The before tax cost of debt= 4.0795%*2= 8.1590%.

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

                                        = 8.1590%*(1- 0.40)

                                        = 4.8964% 4.90%.

Next, the cost of cost of equity is calculated with the help of the dividend discount model.

It is calculated using the below formula:

Ke=D1/Po+g

Where:

D1= Next year’s dividend

Po=Current stock price

g=Firm’s growth rate

Ke= $5*(1 + 0.03)/ $27 + 0.03

     = $5.15/ $27 + 0.03

     = 0.1907 + 0.03

     = 0.0.2207*100

   = 22.07%

WACC= wd*kd(1-t)+we*ke

Where:

Wd=percentage of debt in the capital structure

We=percentage of equity in the capital structure

Kd=cost of debt

Ke=cost of equity

t= tax rate

WACC= 0.35*4.90% + 0.65*22.07%

            = 1.7150 + 14.345

            = 16.0605% 16.06%.

In case of any query, kindly comment on the solution.