XYZ Inc recently hired you as a consultant to estimate the company\'s WACC. You

Question

XYZ Inc recently hired you as a consultant to estimate the company's WACC. You have obtained the following information:

1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $100, and a market price of 105%.

2) The Company's tax rate is 40%.

3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock's beta is 1.20

4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of equity, and it does not expect to issue any new common stock. What is its WACC?

Explanation / Answer

Hi,

Please find the answer as follows:

Step 1: Calculate Cost of Different Instruments:

Cost of Debt:

Nper = 20 (indicates the maturity period of the bonds)

PMT = 1000*.08 = 80 (indicates the annual interest payment)

FV = 1000 (indicates the face value of bonds)

PV = 100*(105%) = 1050 (indicates ths current selling price of the bonds)

Rate = ?

After Tax Cost of Debt = Rate(Nper, PMT, PV , FV) = Rate(20,80,-1050,1000) = 7.51%*(1-.40) = 4.506% or 4.51%

Cost of Equity

Cost of Equity = Risk Free Rate + Beta*(Expected Market Risk Premium) = 4.5 + 1.2*(5.5) = 11.1%

Step 2: Calculate WACC

WACC = After Tax Cost of Debt*Weight of Debt + Cost of Equity*Weight of Equity

WACC = 4.51*35% + 11.1*65% = 8.7935% or 8.79%

Answer is 8.7935% or 8.79%.

Thanks.

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