Eastern Digital has 300,000 shares outstanding which sell for $10 per share. The

Question

Eastern Digital has 300,000 shares outstanding which sell for $10 per share.  The extra risk associated with this stock suggests that the investor should get a return 5% greater than that being paid on its bonds.  The company has 10,000 10year bonds outstanding.  The bonds have a coupon rate of 8% (coupons paid semiannually), a face value of $1,000 and currently sell for $1,100.  The marginal tax rate for this company is 30%.  What is this company’s WACC?

I know that N=20 PV=-1,100 and FV=1,000; but that is it. Someone please help explain this to me!

Explanation / Answer

Answer:

Term of the bond = n = 20 periods

Assume Face value as = FV = $1000

Market value of the bond = MV = $1100

Annual Coupon = 8% per annum and semi-annual coupon = 4%

Therefore YTM = [semi-annual coupon + (FV-MV)/n] / (FV+MV)/2

YTM = [4% x $1000 + ($1000-$1100)/20] / ($1000+$1100)/2

YTM = [40 – 5] / 1050   = 0.03333= 3.33% per half year

Or

YTM (annually) = 6.67% per annum

As return on equity is 5% greater than that of bonds

Therefore cost of equity = 6.67% + 5% = 11.67%

Now total book value of equity = 300,000 x $10 = $3,000,000

And book value of Bonds = $1000 x 1000 = $1,000,000

Therefore weight of equity = ¾ or 75%

And weight of bonds = 25%

Tax rate = 30%

Hence WACC = 75% x 11.67% + (1-30%) x 25% x 6.67%

                        = 8.7525% + 1.16725%

                       = 9.919%.

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