Component cost and WACC
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You are employed by CGT, a Fortune 500 firm that is a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers. You are on the corporate staff as an assistant to the CFO. This is a position with high visibility and the opportunity for rapid advancement, providing you make the right decisions. Your boss has asked you to estimate the weighted average cost of capital for the company. The balance sheet and some other information about CGT follow below.
Assets
Current assets $ 38,000,000
Net plant, property, and equipment 101,000,000
Total assets $139,000,000
Liabilities and equity
Accounts payable $ 10,000,000
Accruals 9,000,000
Current liabilities $ 19,000,000
Long term debt (40,000 bonds, $1,000 par value) 40,000,000
Total liabilities 59,000,000
Common stock (10,000,000 shares) 30,000,000
Retained earnings 50,000,000
Total shareholders equity 80,000,000
Total liabilities and shareholders equity $139,000,000
You check The Wall Street Journal and see that CGT stock is currently selling for $7.50 per share and that CGT bonds are selling for $875.00 per bond. The bonds have a S1,000 par value, a 7.25% annual coupon rate, semiannual payments, are not callable, and a 20-year maturity. CGT's beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The expected return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. CGT is in the 40% tax bracket.
1. What is the best estimate of the after-tax cost of debt for CGT?
2. Using the CAPM approach, what is the best estimate of the cost of equity for CGT?
3. What is the best estimate for the weights to be used to calculate the WACC of CGT?
4. What is the best estimate of the WACC for CGT?
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Solution Summary
The solution explains how to calculate the cost of components of capital and the WACC
Solution Preview
1. What is the best estimate of the after-tax cost of debt for CGT?
The after tax cost of debt is the after tax yield to maturity (YTM) on the existing debt. The YTM can be calculated using a financial calculator as below - for semi annual bonds, periods to maturity are 10X2=20 and semi annual coupon is ...
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