Question

You are given the following information about Firm XYZ: The firm has one zero-coupon bond outstanding that matures in one year and trades at a price of $909. The firm has a beta of 1.5 The risk free rate is 1% The expected return on the market is 11% If the firm is capitalized with equal amounts of debt and equity, what is the weighted average cost of capital, rounded to the nearest percent?

Answer 1

The weighted average cost of capital is computed as shown below:

= cost of debt (1 - tax rate) x weight of debt + cost of equity x weight of equity

cost of debt is computed as follows:

Current value of bond = Par value / (1 + cost of debt)

$ 909 = $ 1,000 / (1 + cost of debt)

1 + cost of debt = $ 1,000 / $ 909

cost of debt = 10.0110% or 0.100110

cost of equity is computed as follows:

= risk free rate + beta ( return on market - risk free rate)

= 0.01 + 1.5 ( 0.11 - 0.01)

= 16% or 0.16

So, the WACC will be computed as follows:

= 0.100110 x (1 - 0) x 0.50 + 0.16 x 0.50

= 13% Approximately

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