Suppose the cost of debt is 6% (before tax). The tax rate is .45. D 0 = $3.25. g

Question

Suppose the cost of debt is 6% (before tax). The tax rate is .45. D0 = $3.25. g = 4%. Beta = 1.60. rRF = 4.10%. RPm = 6%. F (flotation costs) = 5% of issue price. The debt is trading at $998.25 with 7,456 bonds outstanding. The firm has 200,000 shares of common stock outstading, which is trading at $34.85/share (P0).
a. Determine the market value of the firm's debt, the market value of the firm's equity. Then calculate the weight of debt for the firm, and the weight of equity for the firm.
b. What is the cost of existing common equity (retained earnings) and list your method.
c. What is the firm's WACC, describe your approach.

Explanation / Answer

a. Market Value of Debt: Outstanding Bonds x Price Per Bond

Outstanding Bonds: 7,456 Price = $998.25

Market Value = 7,456 x 998.25 = $7,442,952

Market Value of Equity: Outstanding Share x Price Per Share

200,000 x 34.85= $6,970,000

b. Cost of Existing Common Equity according to CAPM model:

Cost of Equity = rf + Beta(rm - rf)

rf = Risk Free Rate of Return , rm = Market Risk Premium

Cost of Equity = 4.10 + 1.60 (6 - 4.10)

Cost of Equity = 7.14%

c. WACC = (Proportion of Equity x Cost of Equity) + (Proportion of Debt x After Tax Cost of Debt)

After Tax Cost of Debt = 0.06 - (1 - 0.45) = 3.30%

Total Market Value = 7,442,952 + 6,970,000 = $14,412,952

Proportion of Debt = 7,442,952 / 14,412,952 = 51.64%

Proportion of Equity = 6,970,000 / 14,412,952 = 48.36%

WACC = (0.4836 x 7.14%) + (0.5164 x 3.30%)

WACC = 5.15%

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