Question

ABC Inc. recently is doing the following financing: (1) The firm's non-callable bonds mature in 20 years, have an 6.00% annual coupon, a par value of $1,000, and a market price of $1,050.00. (2) The company’s tax rate is 40%. (3) The risk-free rate is 5%, the market return is 12%, and the stock’s beta is 1.20. (4) The target capital structure consists of half debt and half equity. The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new shares. What is its WACC?

Answer 1

Cost of Equity [ CAPM ]

= Rf + Beta (Rm – Rf)

= 5% + 1.20 ( 12% - 5% )

= 13.40%

Cost of Debt [ Bond YTM ]

YTM = Coupon Amount + [ (Par Value – Bond Price) / Maturity Years ] / [(Par Value + Bond Price)/2]

= $60 + [ ($1,000 - $1,050) / 20 ) ] / [($1,000 + $1,050) / 2]

= [$60 - $2.50 / $1,025] x 100

= 5.61%

After Tax Cost of Bond = 5.61% x [ 1 - 0.40 ] = 3.37%

Weight of Equity = 50%

Weight of Debt = 50%

Weighted Average Cost of Capital [WACC]

= [ Cost of Equity x Weight of Equity ] + [ Cost of Debt x Weight of Debt ]

= [13.40% x 0.50 ] + [ 3.37% x 0.50 ]

= 6.70% + 1.69%

= 8.39%

“ Hence, Weighted Average Cost of Capital [WACC] = 8.39% “