Its current capital structure is as follows: It has 2,000 5% annual coupon 10 ye
ID: 2753391 • Letter: I
Question
Its current capital structure is as follows:
It has 2,000 5% annual coupon 10 year bonds outstanding which currently trade at 85. The book value for these bonds is $2.0 million. Its common stock sells at $20 per share with 200,000 shares issued and outstanding. Its par value is $5.00 per share and 400,000 shares are authorized. Its common stock has a book value of $23 per share. It has a current beta of 0.8. The risk-free rate is 4.5%, the market rate of return is 11.0%. There is no preferred stock outstanding and there are no plans to issue preferred stock. It is subject to a 40% marginal income tax rate.
a) What is its current after tax cost of debt?
b) What is its current cost of equity?
c) What is its total capital in dollars? What are the weightings of debt and equity to this total capital?
d) What is its current WACC?
Explanation / Answer
a)
Current after tax cost of Debt = Interest rate – Tax on interest
= 5%-0.4*5% = 3%.
b)
Current cost of Equity = Risk free + beta*(Market return-Risk free)
= 0.045 + 0.8*(0.11-0.045)
=0.045+0.052
=0.097 or 9.7%.
c)
Total Capital = Book Value of the bonds + Book value of the shares
= 2,000,000 + 200,000*5
= 3,000,000.
Weight of debt = 2,000,000/3,000,000 = 0.667
Weight of Equity = 1,000,000/3000,000 = 0.333
d)
WACC = Weight of debt * After tax Cost of debt + Weight of Equity *After tax cost of Equity
= 0.667 * 0.03 + 0.333*0.097
= 0.0523 or 5.23%.
Therefore, the WACC is 5.23%.
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