Amresh is interested in estimating the company’s WACC and has collected the following information:
The company has bonds outstanding that mature in 20 years with an annual coupon of 7.5 percent. The bonds have a face value of $1,000 and sell in the market today for $950.
The risk-free rate is 7 percent.
The market risk premium is 6 percent.
The stock’s beta is 1.2.
The company’s tax rate is 40 percent.
The company’s target capital structure consists of 60 percent equity and 40 percent debt.
The company uses the CAPM to estimate the cost of equity and does not include flotation costs as part of its cost of capital. What is Amresh WACC?
Solution: So, amresh WACC = 5.28%, as calculated below:
I. Calculation of cost of equity (through CAPM Method)
ke = Risk free rate of return + Beta x [ Market Rate of Return – Risk free rate of return]
ke = 7% + 1.2 [ 6% -7%]
so, ke = 5.8%
II. Calculation of debenture (kd) =
Interest (1 – tax rate) / Net Proceeds
Interest = $1000 x 7.5% = $75
Net Proceeds = $1000 (assuming issued)
So, kd = $75(1-40%)/$1000 = 4.5%
Now Calculation of WACC
WACC = 1.8% + 3.48% = 5.28%