Question

Wool Express (WE) has a capital structure of 30% debt and 70% equity. WE is considering a project that requires an investment of$2.6 million. To finance this project, WE plans to issue 10-year bonds with a coupon interest rate of 12%. Each of these bonds has a $1,000 face value and will be sold to net WE $980. If the current risk-free rate is 7% and the expected market return is 14.5%, what is the weighted cost of capital for WE? Assume WE has a beta of 1.20 and a marginal tax rate of 40%.

Answer 1

Answer:

13.41%

Explanation:

Given:

Weight of debt =30% ; Weight of equity =70%; Coupon rate =12%

Risk-free rate, $R_{f}$ =7% ; Expected market rate, $R_{m}$=14.5% ; Beta, $\beta$= 1.20; Tax-Rate, $T_{r}$=40%

We can calculate the following thus;

Return on bond = $\frac{Coupon Interest}{Sales price of the bond} =\frac{0.12*1000}{980}=\frac{120}{980} = 12.24$%

Cost of debt =Return on bond *(1-$T_{r}$)=12.24% *(1-0.4)

                     =12.24%*0.6 = 7.35%

To compute the cost of equity capital $K_{e}$, we shall use the CAPM formula below

$K_{e} =R_{f} +\beta (R_{m} - R_{f} )$

                 = 7% + 1.2(14.5%-7.0%)

                  = 7% +1.20( 7.5%) = 7% + 9% = 16%

The Weighted Average Cost of Capital, WACC is worked out as

WACC= (Weight of debt*Cost of debt) + (Weight of equity *Cost of equity)

           = (30% *7.35) +(70% *16)

           = 13.405

           = 13.41%