Question

What is ABC Inc.'s effective annual WACC given the following information? ABC has no outstanding preferred stock ABC does not pay any dividends ABC has one issue of 10,000 bonds outstanding, each priced at $667.15. The bonds have a face value of $1000, pay semi-annual coupons at a rate of 9% APR compounded semi-annually, and mature in 15 years. The next coupon payment is 6-months from today. ABC has 1,000,000 common stock shares outstanding, each priced at $16 per share. The stock has a CAPM LaTeX: \beta=\:β=1.4 Risk-free return is 2% and the expected return of the market is 10%. The firm faces a 28% tax rate.

Answer 1

First to find the cost of debt,

PV of bond = $667.15

FV of bond = $1,000

Semi annual coupon payment P = 0.09 x 1,000 / 2 = $45

Number of compounding periods n = 15 x 2 = 30

PV = P x [1 - (1 + y)ⁿ] / y + FV / (1 + y)ⁿ

667.15 = 45 x [1 - (1 + y)³⁰] / y + 1,000 / (1 + y)³⁰

By trial and error, we get y = 7.25%

Annual cost of debt = y x 2 = 14.5%

To find cost of equity,

r_f = 2%

r_m =10%

beta = 1.4

Cost of equity r_e = r_f + beta x (r_m - r_f) = 2 + 1.4 x (10 - 2) = 13.2%

Total value of debt = 1,000 x 10,000 = $10,000,000

Total value of equity = 16 x 1,000,000 = $16,000,000

Weight of debt w_d = value of debt / (value of debt + value of equity) = 10,000,000 / 26,000,000 = 0.3846

Weight of equity w_e = value of equity / (value of debt + value of equity) = 16,000,000 / 26,000,000 = 0.6154

WACC = w_d x r_d x (1 - t) + w_e x r_e = 0.3846 x 14.5 x (1 - 0.28) + 0.6154 x 13.2 = 12.1385%