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A firm has 2,000,000 shares of common stock outstanding with a market price of $2.00 per share. It has 2,000 bonds outstanding, each selling at 120% of a face value of $1000. The bonds mature in 15 years, have a coupon rate of 10%, and pay coupons annually. The firm's beta is 1.2., the riskfree rate is 5%, and market risk premium is 7%. The tax rate is 34%. Calculate the WACC

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Answer:

10.28 %

Explanation:

WACC is the cost of all sources of capital pooled together. It shows the risk of the company or project.

WACC = Weight of Equity x Cost of Equity + Weight of Debt x Cost of Debt

where,

Weight of Equity = ($2.00 x 2,000,000) ÷ (($2.00 x 2,000,000) + (2,000 x $1,200)) = 0.625

Cost of Equity = Risk free rate + Beta x Market Risk Premium

                        = 5% + 1.2 x 7%

                        = 13.40 %

Weight of Debt = (2,000 x $1,200) ÷  (($2.00 x 2,000,000) + (2,000 x $1,200)) = 0.375

Cost of Debt  is the Yield to Maturity (YTM) of the Bond

PV = ($1,200)

FV = $1,000

N = 15

PMT = $1,000 x 10% = $100

P/YR = 1

YTM = ?

Using a Financial Calculator, YTM is 7.71 %

We always use the after tax cost of debt ;

After tax cost of debt is 5.09 % that is  [7.71 % x ( 1 - 0.34)]

therefore,

WACC = 13.40 % x 0.625 + 5.09 % x 0.375

            = 10.28 %

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