The Collins Group, a leading producer of custom automobile accessories, has hire
ID: 2761242 • Letter: T
Question
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.
Assets
Current assets $ 38,000,000
Net plant, property, and equipment 101,000,000
Total assets $139,000,000
Liabilities and Equity
Accounts payable $ 10,000,000
Accruals 9,000,000
Current liabilities $ 19,000,000
Long-term debt (40,000 bonds, $1,000 par value) 40,000,000
Total liabilities $ 59,000,000
Common stock (10,000,000 shares) 30,000,000
Retained earnings 50,000,000
Total shareholders' equity 80,000,000
Total liabilities and shareholders' equity $139,000,000
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%. Calculate the WACC.
Explanation / Answer
Step1: Computation of the after-tax cost of debt.We have,
Value of Bond = C [1-1/(1+r)n] / r + FV/(1+r)n
If r = 10%
Value of bond = 72.50 [ 1 - 1/(1.10)20 ] / 0.10 + 1,000/(1.10)20
Value of bond = 72.50 [ 1 - 0.14864] / 0.10 + 0.14864 x 1,000
Value of bond = 617.23 + 148.64 = $ 765.87
If r = 5%
Value of bond = 72.50 [ 1 - 1/(1.03)20 ] / 0.05 + 1,000/(1.05)20
Value of bond = 72.50 [ 1 - 0.37689] / 0.10 + 0.37689 x 1,000
Value of bond = 903.51 + 376.89 = $ 1,280.40
Using the interpolation technique.We have,
5 + ( 10-5) ( 1,280.40 - 875) / ( 1,280.4 - 765.87)
= 5 + 5 x 405/514.53
= 5 + 3.93 = 8.93%
Cost of debt = 8.93%
Cost of debt after tax = 8.93 (1 - 0.40) = 5.36%
Step2: Computation of cost of equtiy.We have,
Risk-free rate (Rf) = 5.50%
Beta = 1.25
Return on market = 11.50%
Using the CAPM technique,
Required rate of return = Rf + Beta ( Return on market - Rf)
Required rate of return = 5.50 + 1.25(11.50-5.50) = 5.50 + 7.50 = 13.00%
Step3: Computation of the total market value.We have,
Market Value of debt = 40,000 x 875 = $ 35,000,000
Market value of Equity = 15.25 x 10,000,000 = $ 152,500,000
Total market value = Market value of debt + market value of equity
Total market vlaue = 35,000,000 + 152,500,000 = $ 187,500,000
Step4: Computation of the WACC.We have,
WACC = 35,000,000/187,500,000 X 5.36 + (152,500,000/187,500,000) X 13.00
WACC = 1.00 + 10.57 = 11.57%
Hence,the WACC of the Collins Group is 11.57%.
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