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Cost of Equity, Cost of Debt and WACC

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.

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