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A company has $105 million in outstanding bonds, and 10 million shares of stock currently trading at $34 per share.The bonds pay an annual coupon rate of 7% and is trading at par. The company's beta is 1.2, its tax rate is 40%, the risk-free rate is 3%, and the market risk premium is 6%. What is this firm's WACC

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Answer

Ke = Rf  + β(Rm – Rf)

Ke = 3    + 1.2(6)

Ke = 10.2%

Kd = 7%

WACC = Ke(E/V) + Kd(D/V)(1-T)

WACC = 10.2($340,000,000/$445,000,000) + 7($105,000,000/$445,000,000)(1-0.4)

WACC = 7.79 + 0.99

WACC = 8.78%

Market value of the company:                        $

Market value of equity(10,000,000 x $34) 340,000,000

Market value of bonds                                   105,000,000

Market value of the firm                                 445,000,000

Explanation:

First and foremost, we need to calculate cost of equity using CAPM formula as shown above. In this case, Rf = Risk free rate, β = Beta and market risk premium = Rm - Rf.

We also need to calculate market value of the company, which is the aggregate of market value of equity and market value of bond.

Then WACC is calculated as cost of equity and proportion of equity in the capital structure and after-tax cost of bond and proportion of bond in the capital structure.

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