If Wild Widgets, Inc., were an all-equity company, it would have a beta of 1.65.
ID: 2752255 • Letter: I
Question
If Wild Widgets, Inc., were an all-equity company, it would have a beta of 1.65. The company has a target debt–equity ratio of .5. The expected return on the market portfolio is 10 percent, and Treasury bills currently yield 5.6 percent. The company has one bond issue outstanding that matures in 20 years and has a coupon rate of 10.2 percent. The bond currently sells for $1,240. The corporate tax rate is 35 percent.
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))
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))
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))
If Wild Widgets, Inc., were an all-equity company, it would have a beta of 1.65. The company has a target debt–equity ratio of .5. The expected return on the market portfolio is 10 percent, and Treasury bills currently yield 5.6 percent. The company has one bond issue outstanding that matures in 20 years and has a coupon rate of 10.2 percent. The bond currently sells for $1,240. The corporate tax rate is 35 percent.
Explanation / Answer
(a)
In computing cost of debt (kd), we'll use the debt market value approach.
kd = (Annual coupon payment / current bond price) x (1 - Tax rate)
= ($1,000 x 0.102 / $1,240) x (1 - 0.35)
= 0.0823 x 0.65
= 0.0535
= 5.35%
(b)
Cost of equity, ke = Risk free rate + Beta x (Market return - risk free rate)
= 5.6% + 1.65 x (10 - 5.6)%
= 5.6% + 7.26%
= 12.86%
Note: Risk-free rate = treasury bill rate
(c)
WACC = cost of equity x % of equity + Cost of debt x % of debt
= 12.86% x (2/3) + 5.35% x (1/3)**
= 8.57% + 1.78%
= 10.35%
**If debt/equity = 0.5, Proportion of equity in capital structure = 2/3 (67%) & proportion of debt in capital structure = 1/3 (33%).
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