DATA: -The expected return on the market is 12% -The risk-free rate is 3.5% -Don
ID: 2753516 • Letter: D
Question
DATA:
-The expected return on the market is 12%
-The risk-free rate is 3.5%
-Donuts R Us has a current stock price of $65. There are 15 million shares outstanding. The beta for the stock is 1.6
-Donuts R Us has a plowback ratio of 40%
-Donuts R Us has 3 different bonds issued as follows:
1. 8% coupon bonds with face value of $1000 that mature in 10 years. These bonds have a yield to maturity of 6%. There are 250,000 of these bonds.
2. Zero-coupon bonds with face value of $1000 that mature in 3 years. These bonds have a yield to maturity of 3%. There are 300,000 of these bonds.
3. 10% coupon bonds with face value of $1000 that mature in 15 years and are currently trading at face value. There are 500,000 of these bonds.
-Donuts R Us has an average tax rate of 30%
-Donuts R Us has no preferred stock
A) What is the cost of debt for Donuts R Us?
B) Calculate WACC using market values to obtain weights.
Explanation / Answer
Cost of Debt 1.Market value of 8% Coupon bonds PV=(20000000*((1-(1+0.06)^-10)/0.06))+(250000000/(1+0.06)^10) 286800435.3 ie. $ 286800435 After-tax cost = 0.06*0.70= 0.042 or 4.2% 2.Market value of Zero Coupon bonds PV= (300000000/(1+0.03)^3) 274542497.8 ie. $ 274542498 After-tax cost = 0.03*0.70= 0.021 or 2.1% 3.Market value of 10% Coupon bonds Currently trading @ face value Hence market value is $ 500000000 Price=face value So, YTM= Coupon rate ie. 10% After-tax cost = 0.10*0.70= 0.07 or 7% A. WACC of DEBT Name Market value Wt. to total After-tax cost Wt.* Cost 8% Coupon bonds 286800435 0.2702241 0.042 0.011349 Zero Coupon bonds 274542498 0.25867464 0.021 0.005432 10% Coupon bonds 500000000 0.47110127 0.07 0.032977 Total 1061342933 1 0.049759 So, WACC of debt = 4.98% Cost of Equity= Risk-free rate+ Beta(Market Risk Premium) ie.= Risk-free rate+ Beta(Expected return on the market -Risk Free rate) = 0.035+(1.6*(0.12-0.035)) 0.171 17.10% B. WACC using market values to obtain weights Type of capital Market value Wt. to total After-tax cost Wt.* Cost Equity 975000000 0.47879951 0.171 0.081875 8% Coupon bonds 286800435 0.14084093 0.042 0.005915 Zero Coupon bonds 274542498 0.13482135 0.021 0.002831 10% Coupon bonds 500000000 0.24553821 0.07 0.017188 Total 2036342933 1 0.107809 Overall WACC = 10.78% Alternately Type of capital Market value Wt. to total After-tax cost Wt.* Cost Equity 975000000 0.47879951 0.171 0.081875 Debt 1061342933 0.52120049 0.0498 0.025956 Total 2036342933 1 0.107831 Overall WACC = 10.78%
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