Question

Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, 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 $17.75 per share, and its noncallable $3,319.97 par value, 20-year, 1.70% bonds with semiannual payments are selling for $881.00. The beta is 1.29, 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%. Refer to Exhibit 10.1. Which of the following is the best estimate for the weight of debt for use in calculating the WACC

Answer 1

Answer:

Consider the following calculation

Explanation:

a.) What is the best estimate of the after tax cost of debt ?

Coupon rate 7.25%.

Periods/year 2.

SO PMT = 7.25%*1000/2 = 36.25 Maturity (yr) 20. SO nper = 20*2 =40 Bond price 875 Par value 1000 Tax rate 40% So Annual Yield =2*Rate(nper, pmt,pv,fv) = 2*Rate(40,36.25,-875,1000) = 8.57% SO After-tax cost of debt for use in WACC = rd(1 ? T) = 5.14% ...

Ans (a) (b) based on the CAPM, what is the firms cost of equity? We have P0=15.25, beta=1.25, Krf = Treasuy bill = 5.50%, Ks =11.5% RPm = Exp Mkt return = Krf = Ks-Krf = 11.5%-5.5% = 6% SO CAPM COst of Equity rs = Krf + RPm*Beta ie rs= 5.5% + 6%*1.25 = 13.00%

(c) Weighted WACC Bond Price = 875, No of Bonds = 40,000 So MV of Debt = D = 875*40000 = $35,000,000 Stock price = 15.25, No of shares = 10,000,000 So MV of Equity = E= 152,500,000 Total MV = D+E = 187500,000 SO Weighted Debt = Wd = D/Total MV = 35,000,000/187,500,000 = 18.67% Weighted equity We = E/Total MV = 152500000/187500000 = 81.33% SO WACC = Wd*(1-T)*rd + We*rs = 18.67%*(1-40%)*8.57% + 81.33%*13% ie WACC = 11.53%\)

Answer 2

Based on the amount of debt, the price of the debt and the market value, the best estimate for weight of debt for WACC will be 16.56%.

It is best to use the market weight for the debt when calculating Weighted Average Cost of Capital.

What is the market value of debt?

This can be found as:

= Number of bonds x Price of bonds

= 40,000 x 881

= $35,240,000

What is the market value of Common stock?

= Number of outstanding stock x Price of stock

= 10,000,000 x 17.75

= $177,500,000

What is the weight of debt?

= Amount of debt / (Value of debt + Value of stock)

= 35,240,000 / (35,240,000 + 177,500,000)

= 16.56%

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