Daves Inc. recently hired you as a consultant to estimate the company's WACC. You have obtained the following information. (1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,050.00. (2) The company's tax rate is 40%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock's beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of equity, and it does not expect to issue any new common stock. What is its WACC? a. 8.79% b. 7.54% c. 7.16% d. 8.35% e. 7.93%

correct option is a. 8.79%

Explanation:

given data

bonds mature N = 20 years

annual coupon = 8%

par value FV = $1,000

market price PV = $1,050

tax rate = 40%

risk-free rate = 4.50%

market risk premium = 5.50%

stock's beta = 1.20

target capital structure consists =  35%  

solution

we gte here first Annual coupon payment

PMT = 8% × 1000     1

PMT = 80

we get here YTM of the bond (rD)

we can use financial calculator

here pretax cost of debt, rd

CPT I/Y = 7.51%

Now we get

cost of equity (rE) with help of CAPM

CAPM; r = risk free + beta (Market risk premium)   2

so

rE = 0.0450 + 1.20 × (0.0550)

rE = 0.0450 + 0.066

rE = 11.1 %

so we can get here WACC that is

WACC =  wE × rE + wD × rD × (1-tax)    3

here rD is pretax cost of deb and w is weight

so

WACC  = (0.65×0.111) + [0.35×0.0751×(1-0.40) ]

WACC = 0.0879

WACC = 8.79%

correct option is a. 8.79%

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