Jack's Construction Co. has 80 bonds outstanding that are selling at their par value of ₹1,000 each. Bonds with similar characteristics are yielding a pretax 8.6 percent. The firm also has 4,000 shares of common stock outstanding. The stock has a beta of 1.1 and sells for ₹40 a share. The U.S. T-bill is yielding 4 percent, the market risk premium is 8 percent, and the firm's tax rate is 21 percent. What is the firm's weighted average cost of capital assuming its earnings are sufficient to classify all interest as a tax-deductible expense?
Question
Jack's Construction Co. has 80 bonds outstanding that are selling at their par value of ₹1,000 each. Bonds with similar characteristics are yielding a pretax 8.6 percent. The firm also has 4,000 shares of common stock outstanding. The stock has a beta of 1.1 and sells for ₹40 a share. The U.S. T-bill is yielding 4 percent, the market risk premium is 8 percent, and the firm's tax rate is 21 percent. What is the firm's weighted average cost of capital assuming its earnings are sufficient to classify all interest as a tax-deductible expense?
Solution
To calculate the firm's weighted average cost of capital (WACC), we need to find the cost of debt and the cost of equity first.
- Cost of Debt (Kd):
The cost of debt is the effective rate that a company pays on its current debt. In this case, the bonds are yielding a pretax 8.6 percent. However, as the interest on the debt is tax-deductible, we need to calculate the after-tax cost of debt.
Kd = Yield * (1 - Tax Rate) Kd = 8.6% * (1 - 21%) Kd = 6.794%
- Cost of Equity (Ke):
The cost of equity is estimated using the Capital Asset Pricing Model (CAPM) which is:
Ke = Risk-free rate + Beta * Market Risk Premium Ke = 4% + 1.1 * 8% Ke = 12.8%
- Weighted Average Cost of Capital (WACC):
The WACC is the average rate of return a company is expected to pay its investors; the weights are the proportion of debt and equity in the company's capital structure.
The total market value of the firm's equity (E) is the number of shares times the market price per share, which is 4,000 * ₹40 = ₹160,000.
The total market value of the firm's debt (D) is the number of bonds times the par value of each bond, which is 80 * ₹1,000 = ₹80,000.
So, the weights of equity and debt are E/V and D/V respectively, where V is the total market value of the firm's equity and debt, which is ₹160,000 + ₹80,000 = ₹240,000.
Weight of Equity (We) = E/V = ₹160,000 / ₹240,000 = 0.6667 Weight of Debt (Wd) = D/V = ₹80,000 / ₹240,000 = 0.3333
Now, we can calculate the WACC:
WACC = We * Ke + Wd * Kd WACC = 0.6667 * 12.8% + 0.3333 * 6.794% WACC = 10.53%
So, the firm's weighted average cost of capital is 10.53%.
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