The Collins Group, a leading producer of custom automobile accessories, has hire
ID: 2764788 • Letter: T
Question
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below. (20 year T-bond and the required return of stock market.
Assets
Current assets $ 38,000,000
Net plant, property, and equipment 101,000,000
Total assets $139,000,000
Liabilities and Equity
Accounts payable $ 10,000,000
Accruals 9,000,000
Current liabilities $ 19,000,000
Long-term debt (40,000 bonds, $1,000 par value) 40,000,000
Total liabilities $ 59,000,000
Common stock (10,000,000 shares) 30,000,000
Retained earnings 50,000,000
Total shareholders' equity 80,000,000
Total liabilities and shareholders' equity $139,000,000
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%. Calculate the WACC.
When calculate the cost of equity, use the the yield on 20 year T-bond and the required return of stock market.
Explanation / Answer
Cost of equity, ke (%) = Risk-free rate (T-bill yield) + Beta x [Required market return - Risk-free rate]
= 5.5 + 1.25 x [11.5 - 5.5]
= 5.5 + 1.25 x 6
= 5.5 + 7.5
= 13
For the bond,
C: Semi-Annual coupon rate = $1000 x 7.25% x (1/2) = $36.25
N: Number of periods = 20 x 2 = 40
F: Bond face value = $1000
P: Bond's current price = $875
Then, using approximation method,
Yield (YTM) = [C + (F - P) / N] / [(F + P) / 2]
= [36.25 + (1000 - 875) / 40] / [(1000 + 875) / 2]
= [36.25 + (125 / 40)] / [1875 / 2]
= [36.25 + 3.125] / 937.5
= 39.375 / 937.5
= 0.042, or 4.2%
Then, post-tax cost of debt, kd = YTM x (1 - tax rate) = 4.2% x (1 - 0.4) = 4.2% x 0.6 = 2.52%
Total capital = long term debt + Equity = $(40,000,000 + 30,000,000) = $70,000,000
Proportion of debt = $40,000,000 / $70,000,000 = 0.5714
Proportion of equity = 1 - 0.5714 = 0.4286
WACC = Proportion of debt x kd + Proportion of equity x ke
= 0.5714 x 2.52% + 0.4286 x 13%
= 1.44% + 5.57%
= 7.01%
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