You have been asked to estimate the cost of capital for the CAT Corporation. The

Question

You have been asked to estimate the cost of capital for the CAT Corporation. The company has 4 million shares and 125,000 bonds outstanding at a par value of $1,000. In addition, it has $20 million in short-term debt from its bank. The target capital structure ratio is 55% equity, 40% long-term debt, and 5% short-term debt. The current capital structure has temporarily moved slightly away from the target ratio.The company's shares currently trade at $50 with a beta of 1.03. The book value of the shares is $16. The annual coupon on the bond is 9%, they trade at 108 percent of par, and they will mature in 10 years. Interest on the short-term debt is 3.5%. The current yield on a ten-year government bond is 5.2%. The market risk premium is 5% The corporate tax rate applicablle is expeted to be 35%.Based on these data, calculate the cost of capital for the CAT Corporation.

Calculate and Show work:

1. Cost of Debt (KD) - before tax

Kd =

2. Cost of Equity (KE)

KE =

3. Cost of short-term debt (KS) - before tax

KS=

4. Weighted-average cost of capital (WACC)

(KD (1-T) Wd) + (KE (WE)) + (KS (1-T) WS)

Explanation / Answer

Cost of Equity = Risk Free Rate + Beta * Market Risk Premium

Cost of Equity = 5.2% + 1.03 * 5%

Cost of Equity = 10.35%

Cost of Short Term Debt = 3.5%

We will calcualte cost of long term debt by financial calculator:

FV = 1,000

PV = 1,080

Coupon Rate = 90

Years to maturity = 10

By using financial calculator:

r = 7.82%

Cost of debt = 7.82%

Market capital of Equity = 4,000,000 * 50

Market capital of Equity = 200,000,000

Market capital of Long Term Debt = 125,000 * 1,080

Market capital of Long Term Debt = 135,000,000

Market capital of Short Term Debt = 20,000,000

Market capital of Short Term Debt = 20,000,000

WACC = (135,000,000/ (135,000,000 + 200,000,000 + 20,000,000) * 7.82% * (1 - 35%)) + (200,000,000/ (135,000,000 + 200,000,000 + 20,000,000) * 10.35% ) + (20,000,000/ (135,000,000 + 200,000,000 + 20,000,000) * 3.5% * (1 - 35%))

WACC = 1.93 + 5.83 + 0.13

WACC = 7.89%

Related Questions

Navigate

• Browse (All)
• Browse Y
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.