Question

The table below shows a book balance sheet for the Wishing Well Motel chain. The company’s long-term debt is secured by its real estate assets, but it also uses short-term bank loans as a permanent source of financing. It pays 12% interest on the bank debt and 9% interest on the secured debt. Wishing Well has 10 million shares of stock outstanding, trading at $90 per share. The expected return on Wishing Well’s common stock is 18%. (Table in $ millions.)

Cash and marketable securities	$	180		Bank loan	$	320
Accounts receivable		340		Accounts payable		180
Inventory		50		Current liabilities	$	500
Current assets	$	570
Real estate		2,650		Long-term debt		2,350
Other assets		130		Equity		500
Total	$	3,350		Total	$	3,350

Calculate Wishing Well’s WACC. Assume that the book and market values of Wishing Well’s debt are the same. The marginal tax rate is 35%. (Do not round intermediate calculations. Enter your answer as a percent rounded to 1 decimal place.)

Weighted-average cost of capital             %

Answer 1

Answer:

Market Value of Bank Loan = $320
Market Value of Long term Debt = $2,350
Market Value of Equity = 10 * $90 = $900

Market Value of Firm = $320 + $2,350 + $900
Market Value of Firm = $3,570

Weight of Bank Loan = $320 / $3,570
Weight of Bank Loan = 0.0896

Weight of Long Term Debt = $2,350 / $3,570
Weight of Long Term Debt = 0.6583

Weight of Equity = $900 / $3,570
Weight of Equity = 0.2521

After Tax Cost of Bank Debt = 12% * (1 – 0.35)
After Tax Cost of Bank Debt = 7.80%

After Tax Cost of Long Term Debt = 9% * (1 – 0.35)
After Tax Cost of Long Term Debt = 5.85%

WACC = (Weight of Bank Loan * After Tax Cost of Bank Debt) + (Weight of Long Term Debt * After Tax Cost of Long Term Debt) + (Weight of Equity * Cost of Equity)
WACC = (0.0896 * 7.80%) + (0.6583 * 5.85%) + (0.2521 * 18.00%)
WACC = 0.6989% + 3.8511% + 4.5378%
WACC = 9.1%