Question

Biden Resorts Company currently has 0.2 million common shares of stock outstanding and the stock has a beta of 2.2. It also has $1 million face value of bonds that have five years remaining to maturity and 8 percent coupon with semi-annual payments, and are priced to yield 13.65 percent. If Biden issues up to $2.5 million of new bonds, the bonds will be priced at par and have a yield of 13.65 percent; if it issues bonds beyond $2.5 million, the expected yield on the entire issuance will be 16 percent. Biden has learned that it can issue new common stock at $10 a share. The current
risk-free rate of interest is 3 percent and the expected market return is 10 percent. Biden's marginal tax rate is 30 percent. If Biden raises $7.5 million of new capital while maintaining the same debtto-equity ratio, its weighted average cost of capital is?

Answer 1

Answer:

Hence, the weighted average cost of capital is 15.87%.

Explanation:

We have to find current weights,  

Value of equity = Shares x Share price = 0.2 x 10 = $2 million  

Face Value of Bonds FV = $1 million

Semi annual coupon P = 1 x 8% / 2 = $0.04 million

Number of coupons remaining n = 5 x 2 = 10

Semi annual yield r = 13.65% / 2 = 6.825%

Value of Debt = Px [1 - (1 + r)-n] / r + FV / (1 + r)n

= 0.04 x [1 - (1 + 0.06825)-10] / 0.06825 + 1 / (1 + 0.06825)10

= $0.8 million

Total Value = 2 + 0.8 = $2.8 million

Weight of Debt = 0.8 / 2.8 = 28.57%

Weight of Equity = 2 / 2.8 = 71.45%

Amount of Debt to be raised = Weight of debt x Capital

= 0.2857 x 7.5

= $2.14 million

Since the amount of debt to be raised is less than $2.5 million, the yield will be 13.65%  

Cost of Equity = Risk Free Rate + Beta x (Market Return - Risk Free Rate)

= 3% + 2.2 x (10 - 3)

= 18.4%

The weighted average cost of capital:-  

WACC = Weight of Debt x Cost of Debt x (1 -Tax Rate) + Weight of Equity x Cost of Equity

= 0.2857 x 13.65% x (1 - 0.3) + 0.7145 x 18.4%

= 15.87%