You have been given the following facts and assumptions concerning ABC Corp. at
ID: 2726220 • Letter: Y
Question
You have been given the following facts and assumptions concerning ABC Corp. at December 31, 2013. Yield to maturity on long term government bond is 5.00%. Yield to maturity on company long term government bond is 7.0%.Coupon rate on company long term bond is 7.0%.Market price of risk is 8.0% along with estimated company beta value of 1.5.Stock is selling for $40 in the market and 250 million shares are outstanding. Assuming that book value of equity is $5240 million along with book value of interest bearing debt of $1250 million. Existing tax rate stands at 35%.Given all the information estimate the ABC Corp's weighted average cost of capital.
Explanation / Answer
1.
Risk free rate = Yield to maturity of long term government bonds = 5%
Beta = 1.5
Market risk premium = Market price of risk = 8%
As per CAPM,
Cost of equity = Expected return on equity = Risk free rate + Beta*Market risk premium = 5% + (1.5*8%) = 5%+12% = 17%
2.
Pre tax cost of debt capital = Yield to maturity on company long term bonds = 7%
After tax cost of debt = Pretax cost of debt * (1 - tax rate) = 7% * (1 - 0.35) = 4.55%
3.
Market value of equity = $40 * 250 million shares = $10,000 million
Coupon rate of long term bond is equal to its YM, hence market value of bon is equal to its book value i.e.$1250 million
Market value
Weight (Market value/Total market value)
Cost of capital
Weighted cost of capital
Equity
$ 10,000
0.89
17%
15.11%
Debt
$ 1,250
0.11
4.55%
0.51%
$ 11,250
15.62%
Hence, weighted average cost of capital = 15.62%
Market value
Weight (Market value/Total market value)
Cost of capital
Weighted cost of capital
Equity
$ 10,000
0.89
17%
15.11%
Debt
$ 1,250
0.11
4.55%
0.51%
$ 11,250
15.62%
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