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A firm has 2,000,000 shares of common stock outstanding with a market price of $2.00 per share. It has 2,000 bonds outstanding, each selling for $1,200. The bonds mature in 15 years, have a coupon rate of 10% and pay coupons annually. The firm's beta is 1.2, the risk free rate is 5%, and the market risk premium is 7%. The tax rate is 34%. Calculate the WACC?
Answer:
Cost of Debt : The cost of debt is the YTM on the curent debt. (I don't understand this concept)
The YTM is the discount rate that will make the PV of interest and principal equal to the price today. (explain)
The interest amount is $100 and the principal is $1,000 (how are these amounts calculated?)
Period is 15 years. Use RATE function in excel to get the YTM. Put NPER=15, PMT=100, PV=-1,200 and FV=1,000. The YTM comes to 7.71%. Since interest is tax deductible, we use the after tax cost of debt. After tax cost is 7.71%(1-0.34)=5.08%
Cost of Equity : Use the CAMP equation to get the cost of equity
Cost of Equity = Riskfree rate + Market risk premium X beta
Cost of Equity = 5% + 7% X 1.2 = 13.4%
Market Value of Debt : 2,000X1,200=2,400,000
Market Value of Equity : 2,000,000 X 2 = 4,000,000
Total market value of capital : 6,400,000
WACC = Proportion of debt x cost of debt + proportion of equity X cost of equity
WACC = 2,400,000/6,400,000 X 5.08% + 4,000,000/6,400,000 X 13.4%
WACC = 10.28%
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