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Cost of Equity, Cost of Debt and WACC

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Common stocks of the Anders Company which currently has no debt in its capital structure are trading for $50 a share. Threes has 2 million shares outstanding now. Threes Co. uses the CAPM in estimating costs of capital. The (unlevered) equity beta for Threes Co. is 1.25, and the risk-free rate and the market portfolio return are expected to be 5% and 13%, respectively. Its income tax rate is 35%.

Mr. Anderson, the Vice-President of Finance, is considering changing its financing policy to actively maintain a target debt ratio of 20% (or 25% debt-to-equity ratio) of the levered firm. An investment bank informed him that Threes may be able to issue 10-year $1,000 par bonds for $922.05 per bond if it offers 4.0% annual coupons, or for $1,116.92 per bond if it offers 6.5% annual coupons. Coupons will be paid semi-annually. Threes plans to keep refinancing bonds at maturity to effectively make bonds perpetual.

Compute: i) cost of equity at the target leverage ratio, ii) cost of debt, and iii) the WACC of the Anders Co.

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Solution Preview

1. Cost of equity using CAPM = Rf + (Rm-Rf) beta where
Rf = risk free rate = 5%
Rm = market return = 13%
beta = levered beta
We are given the unlevered beta = 1.25. The levered beta is calculated as
Levered Beta = Unlevered BetaX(1 + ...

Solution Summary

The solution explains the calculation of cost of equity,cost of debt and WACC

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Cost of Debt, cost of equity, weighted average cost of capital

If Wild Widgets, Inc., (WWI) were an all-equity firm, it would have a beta of 0.9.WWI has a target debt-to-equity ratio of 0.50.The expected return on the market portfolio is 16 percent, and Treasury bills currently yield 8 percent per annum.WWI one-year, $1,000 par value bonds carry a 7 percent annual coupon and are currently selling for $972.73.The yield on WWI's longer term debt is equal to the yield on its one-year bonds. The corporate tax rate is 34 percent.
a. What is WWI's cost of debt?
b. What is WWI's cost of equity?
c. What is WWI's weighted average cost of capital?

Please see the attached file(s).

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