A firm uses only debt and common stock to finance their operations and maintains

Question

A firm uses only debt and common stock to finance their operations and maintains a debt-equity ratio of 0.8. Suppose the firm only issues one bond. The information is as follows: the face value of bond is 1,000. Coupon rate is 6%, paid semiannually. The current price of the bond is $950. There are 7 years before the bond matures. The current stock price is $50. The dividend paid for next year is expected to be $1. The dividend has constant growth rate of 2%. If the tax rate is 30%, please calculate before-tax cost of debt and cost of equity. What is the weighted average cost of capital?

Explanation / Answer

Present value of bond = Coupon1 / (1+YTM^1) +.........................+ {Coupon14 + Face value } / (1+YTM)^14

950 = 30 / (1+YTM)^1 +........................+ {30+1000} /(1+YTM)^14 =3.45%semannually or 7% annually which is the before tax cost of debt .

Cost of equity =[ Dividend / Price ]+ Growth rate = [ 1 / 50 ] + 2% = 4%

Weighted average cost of capital = Cost of debt (1- tax rate ) * weight of debt + Cost of equity * weight of equity

7%(1- 0.3) * 0.8/ 1 + 4% *0.2 / 1 = 0.0392 + 0.008 = 0.0472 or 4.72%

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