Question

BC Corporation has 2.8 million shares of stock outstanding. The stock currently sells for $50 per share. The firm’s debt is publically traded and was recently quoted at 95 percent of its face value. It has a total face value of $10 million, and it is currently priced to yield 12 percent. The risk-free rate is 5 percent, and the market risk premium is 7 percent. You’ve estimated that ABC has a beta of 1.25. If the corporate tax rate is 35 percent, what is the WACC of ABC Corporation?

Answer 1

Answer:

The WACC is 13.37%

Explanation:

The WACC or weighted average cost of capital is the cost of a firm's capital structure. The capital structure is made up of debt, preferred stock and common stock. In this question, there are only two components present in the capital structure i.e. debt and common stock.

The formula for WACC is,

WACC = wD * rD * (1 - tax rate)  +  wE * rE

Where,

• w represents the weight of each component in the capital structure or value of each component as a proportion of total assets
• r represents the cost of each component
• we take after tax cost of debt. So we multiply cost of debt by (1 - tax rate)

We first need to determine the cost of equity using the CAPM,

rE = 0.05 + 1.25 * 0.07   =  0.1375 or 13.75%

We know that assets = debt + equity

Assets = (0.95 * 10)  +  (2.8 * 50)

Assets = 9.5  +  140  

Assets = 149.5 million

The WACC for ABC is:

WACC = 9.5/149.5  *  0.12  *  (1 - 0.35)  +  140/149.5  *  0.1375

WACC = 0.1337 or 13.37%