ExpertHard1 markMultiple Choice
CPA · Question 08 · Area I: Business Analysis
A company has the following capital structure:<br/>- Debt: $4,000,000 par value bonds, 6% coupon, currently trading at 102. Flotation costs are negligible.<br/>- Equity: 500,000 shares outstanding, current price $25 per share. Beta is 1.2.<br/>- Risk-free rate is 3%; Market risk premium is 5%.<br/>- Corporate tax rate is 25%.<br/><br/>What is the company's Weighted Average Cost of Capital (WACC)?
A company has the following capital structure:<br/>- Debt: $4,000,000 par value bonds, 6% coupon, currently trading at 102. Flotation costs are negligible.<br/>- Equity: 500,000 shares outstanding, current price $25 per share. Beta is 1.2.<br/>- Risk-free rate is 3%; Market risk premium is 5%.<br/>- Corporate tax rate is 25%.<br/><br/>What is the company's Weighted Average Cost of Capital (WACC)?
Answer options:
A.
6.8%
B.
7.5%
C.
7.9%
D.
8.4%
How to approach this question
1. Calculate Market Value of Debt and Equity. 2. Calculate Weights. 3. Calculate Cost of Equity (CAPM). 4. Calculate After-tax Cost of Debt (Effective rate * (1-Tax)). 5. WACC = We*Re + Wd*Rd.
Full Answer
C.7.9%✓ Correct
C
MV Debt = $4,000,000 * 1.02 = $4,080,000<br/>MV Equity = 500,000 * $25 = $12,500,000<br/>Total Value = $16,580,000<br/>Weight Debt = 24.6%<br/>Weight Equity = 75.4%<br/><br/>Cost of Equity (Re) = 3% + 1.2(5%) = 9%<br/>Cost of Debt (Rd) = (6% / 1.02) * (1 - 0.25) = 5.88% * 0.75 = 4.41% (Using current yield as proxy for YTM)<br/>WACC = (0.754 * 9%) + (0.246 * 4.41%) = 6.79% + 1.08% = 7.87% -> approx 7.9%.
Common mistakes
Using book values; forgetting tax shield on debt; using coupon rate directly without tax adjustment.
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