Jack\'s Construction Co. has 100,000 bonds outstanding that are selling at par v
ID: 2654960 • Letter: J
Question
Jack's Construction Co. has 100,000 bonds outstanding that are selling at par value. The bonds yield 9.7 percent. The company also has 4.2 million shares of common stock outstanding. The stock has a beta of 1.4 and sells for $20 a share. The U.S. Treasury bill is yielding 4 percent and the market risk premium is 7 percent. Jack's tax rate is 35 percent. What is Jack's weighted average cost of capital?
4.87 percent
10.37 percent
6.30 percent
2.87 percent
9.73 percent
Jack's Construction Co. has 100,000 bonds outstanding that are selling at par value. The bonds yield 9.7 percent. The company also has 4.2 million shares of common stock outstanding. The stock has a beta of 1.4 and sells for $20 a share. The U.S. Treasury bill is yielding 4 percent and the market risk premium is 7 percent. Jack's tax rate is 35 percent. What is Jack's weighted average cost of capital?
4.87 percent
10.37 percent
6.30 percent
2.87 percent
9.73 percent
Explanation / Answer
Jack's weighted average cost of capital using the formula :
WACC = r(E) × w(E) + r(D) × (1 – t) × w(D)
Cost of equity
In the formula for WACC, r(E) is the cost of equity i.e. the required rate of return on common stock of the company. It is the minimum rate of return which a company must earn to keep its common stock price from falling. Cost of equity is estimated using different models, such as dividend discount model (DDM) and capital asset pricing model (CAPM).
After-tax cost of debt
In the WACC formula, r(D) × (1 – t) represents the after-tax cost of debt i.e. the after-tax rate of return which the debt-holders need to earn till the maturity of the debt. Cost of debt of a company is based on the yield to maturity of the relevant instruments. If no yield to maturity is available, the cost can be estimated using the instrument's current yield, etc. After-tax cost of debt is included in the calculation of WACC because debt offers a tax shield i.e. interest expense on debt reduces taxes. This reduction in taxes is reflected in reduction in cost of debt capital.
Weights
w(E) is the weight of equity in the company’s total capital. It is calculated by dividing the market value of the company’s equity by sum of the market values of equity and debt.
w(D) is the weight of debt component in the company’s capital structure. It is calculated by dividing the market value of the company’s debt by sum of the market values of equity and debt.
comes to 10.37 percent.
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