ABC firm has $2 million of capital needs. ABC firm has noticed that the current

Question

ABC firm has $2 million of capital needs. ABC firm has noticed that the current yield to maturity on its bonds is 9.5%, and its stock beta is 1.45. Currently, the expected return on the S&P 500 stocks is 11.5%, and the 10-year T-bond rate is 2.35%. The firm plans to raise $0.8 million in debt and $1.2 million in equity. The firm’s marginal tax rate is 28%. a. What is the cost of debt? 9.5% (1- 0.28) = 6.84% b. What is the cost of equity? 2.35% + [ 11.5 – 2.35] 1.45 = 15.62 % c. What is the cost of capital for the $2 million?

Explanation / Answer

a.

Cost of debt = YTM on the bond = 9.5%

b.

Cost of equity:

According to CAPM,

Cost of equity = risk free rate + beta*(Market return - risk free rate)

= 2.35% + 1.45*(11.5%-2.35%) = 15.6175%

c.

WACC = rD (1- Tc )*( D / V )+ rE *( E / V )

Where...

rD = The required return of the firm's Debt financing
(1-Tc) = The Tax adjustment for interest expense
(D/V) = (Debt/Total Value)
rE= the firm's cost of equity
(E/V) = (Equity/Total Value)

WACC = 0.8/2*0.095*(1-0.28) + 1.2/2*0.156175 = 12.1065% = 12.11%

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