Daves Inc. recently hired you as a consultant to estimate the company’s WACC. Yo

Question

Daves Inc. recently hired you as a consultant to estimate the company’s WACC. You have obtained the following information.(1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,050.00. (2) The company’s tax rate is 40%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock’s beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new shares (so no flotation costs). What is its WACC?  

7.16%

7.54%

7.93%

8.35%

8.79%

Daves Inc. recently hired you as a consultant to estimate the company’s WACC. You have obtained the following information.(1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,050.00. (2) The company’s tax rate is 40%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock’s beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new shares (so no flotation costs). What is its WACC?  

A

7.16%

B

7.54%

C

7.93%

D

8.35%

E

8.79%

Explanation / Answer

Solution:

Note - Since, the market price or market value of equity shares is not given, therefore, market value or prices are not used in order to calculate weights for the cost of capital.

Thus, weights given in the question are used.

Weghted Average Cost of Capital ( WACC ) Weights Cost Weighted Cost Debt 35% 4.80% 1.68% Equity 65% 11.10% 7.22% Total 100% 8.90% Working - 1. Cost od Debt of = Annual Coupon * ( 1 - Tax Rate) Cost of Debt= 8 % * ( 1 - 40 % ) 2. Cost of Equity - Cost of Equity = Risk Free Rate + Beta * (   Expected market return - risk free rate ) Risk Free Rate + Beta * ( Expected market risk premimum) 4.50 % + 1.20 * 5.50 % = 11.10 %

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