Question

If Wild Widgets, Inc., were an all-equity company, it would have a beta of 0.90. The company has a target debt-equity ratio of 0.75. The expected return on the market portfolio is 11 percent and Treasury bills currently yield 3.6 percent. The company has one bond issue outstanding that matures in 20 years, a par value of $1,000, and a coupon rate of 6.5 percent. The bond currently sells for $1,075. The corporate tax rate is 23 percent.

Required:
a. What is the company's cost of debt?
b. What is the company's cost of equity?
c. What is the company's weighted average cost of capital?

Answer 1

Answer:

7.89% or 7.9% or 8%

Explanation:

a.

Cost of debt is the cost incurred on the debt financing.

Yield to maturity is the cost of debt we will use following formula to calculate it.

Coupon Payment = C = $1,000 x 6.5% = $65

Number of periods = n = 20 years x 2 = 40 period

Current Market price = PV = $1,075

Yield to maturity = [ C + ( F - P ) / n ] / [ (F + P ) / 2 ]

Yield to maturity = [ 65 + ( $1,000 - $1,075 ) / 40 ] / [ ( $1,000 - $1,075 ) / 2 ]

Yield to maturity = 6.08%

Now Calculate Cost of equity

b.

Capital asset pricing model measure the expected return on an asset or investment. it is used to make decision for addition of specific investment in a well diversified portfolio.

Formula for CAPM

Expected return = Risk free rate + beta ( Market rate - Risk free rate )

Expected return = 3.9% + 0.9 ( 11% - 3.9% )

Expected return = 3.9% + 6.39%

Expected return = 10.29%

c.

WACC is the average cost of capital of the firm based on the weightage of the debt and weightage of the equity multiplied to their respective costs.

According to WACC formula

WACC = ( Cost of equity x Weightage of common stock ) + ( Cost of debt ( 1- t) x Weightage of debt )

WACC = ( 10.29% x 1 /1.75 ) + ( 6.08% ( 1 - 0.23 ) x 0.75/1.75 )

WACC = 5.88% + 2.01% = 7.89%