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Cost of Debt, Cost of Equity, and WACC for Wild Widgets, Inc.

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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%, and Treasury bills currently yield 8% per annum. WWI one-year, $1,000 par value bonds carry a 7% 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%.

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?

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Solution Summary

Given the beta, target debt-to-equity ratio, tax rate, and yields, find a firm's cost of debt, cost of equity, and WACC.

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a. In order to determine the cost of the firm's debt (rB), solve for the discount rate that makes the present value of the bond's future cash flows equal to the bond's current price.

Since WWI's one-year, $1,000 par value bonds carry a 7% coupon, bond holders will receive a payment of $1,070 =[$1,000 + (0.07)($1,000)] in one year.

$972.73 = $1,070/ (1+ rB)
rB = 0.10

So, the cost of WWI's debt is 10%.

b. Use the Capital Asset Pricing Model to find the return on WWI's unlevered equity (r0).

According to the Capital Asset Pricing Model:

r0 = rf + βUnlevered(rm - rf)

where r0= the cost of a firm's unlevered equity
rf= the risk-free rate
rm= the expected return on the market ...

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