WACC (Weight Average Cost of Capital)

Kose Inc., has a target debt – equity ratio of 0.65. Its WACC is 11.2 percent, and the tax rate is 35 percent.
a. If Kose’s cost of equity is 15 percent, what is its pretax cost of debt?
b. If instead you know that the aftertax cost of debt is 6.4 percent, what is the cost of equity?

a. Using the equation to calculate WACC, we find:

WACC = (S/S+B) RE + (B/S+B)RD
                WACC = 0.112 = (1/1.65)(0.15) + (0.65/1.65) (1-0.35) RD
                0.112 = 0.09091 + 0.2560 RD
                        0.112 – 0.09091 = 0.2560 RD
                RD = 0.0824 = 8.24%

b. WACC = (S/S+B) RE + (B/S+B)RD
0.112 = (1/1.65)RE + (0.65/1.65)(0.064)
0.112 = 0.6060 RE  + 0.02521
0.112 – 0.02521 = 0.6060 RE
RE = 0.1432 = 14.32%


Given the following information for Huntington Power Co., find the WACC. Assume the company’s tax rate is 35 percent.
Debt:                 5,000 8 percent coupon bonds outstanding, $1,000 par value, 20 years to maturity, selling for 103 percent of par, the bonds make semiannual payments.
Common stock:    160,000 shares outstanding, selling for $57 per share, the   beta is 1.10.
Market:               7 percent market risk premium and 6 percent risk – free rate.

We will begin by finding the market value of each type of financing. We find:

Market Value Debt: 5,000 ($1,000) (1,03) = $5,150,000
Market Value Equity: 160,000 ($57) = $9,120,000

And total the market value of the firm is:
$5,150,000 + $9,120,000 = $14,270,000

Now we can find the cost of equity using the CAPM. The cost of equity is:
Rs = RF + β (RM – RF)
Rs = 0.06 + 1.10 (0.07)
Rs = 0.137 = 13,7%

The cost of debt is the YTM of the bonds, so:
P0 = $1,030 = $40(PVIFAR%, 40) + $1,000(PVIFR%, 40)
R = 3,851%
YTM = 7.70

And the aftertax cost of debt is:

RD = (1 – 0.35) (0.0770) = 0.0501

Now we have all of the components to calculate the WACC. The WACC is:

WACC = (S/S+B) Rs + (B/S+B)RD
 = 0.137 (9,120,000/14,270,000) + (5,150,000/14,270,000)0.0501
= 0.0876 + 0.0181
= 0.106
= 10.6%


Reference:
Corporate Finance Book, Stephen A.Ross, Randolph W.Westerfield and Jeffrey Jaffe, Ninth Edition. Chapter 13, questions and problems  number 12 & 13 page 422 – 423.

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