If Wild Widgets, Inc., were an all-equity company, it would have a beta of 1.15

Question

If Wild Widgets, Inc., were an all-equity company, it would have a beta of 1.15. The company has a target debt–equity ratio of .6. The expected return on the market portfolio is 10 percent, and Treasury bills currently yield 3.6 percent. The company has one bond issue outstanding that matures in 20 years and has a coupon rate of 8.2 percent. The bond currently sells for $1,140. The corporate tax rate is 35 percent.

a.

What is the company’s cost of debt? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

   Cost of debt

%

b.

What is the company’s cost of equity? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

   Cost of debt

%

c.

What is the company’s weighted average cost of capital? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

   WACC

%

If Wild Widgets, Inc., were an all-equity company, it would have a beta of 1.15. The company has a target debt–equity ratio of .6. The expected return on the market portfolio is 10 percent, and Treasury bills currently yield 3.6 percent. The company has one bond issue outstanding that matures in 20 years and has a coupon rate of 8.2 percent. The bond currently sells for $1,140. The corporate tax rate is 35 percent.

Explanation / Answer

a.

K = N          
BOND PRICE= [(Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N
                   k=1

                    K = 20   
1140 = [(8.2*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^20
                   k=1

YTM = 6.889%

B

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

= 1.15*(1+((1-0.35)*(0.6))) = 1.5985

cost of equity= risk-free rate + beta * (expected return on the market - risk-free rate)

3.6+1.5985*(10-3.6) = 13.83%

C)

D/E = .6/1

D/A = D/(D+E) = .6/(1+.6 ) = 0.375

E/A = 1-D/A = 1-.375 = 0.625

WACC = wd(rd)(1 – T) + wc(rs) = .375*6.889*(1-0.35)+.625*13.83 = 10.32%

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