Chapter 8 Problem 20 Key facts and assumptions concerning Kroger Company, at Dec

Question

Chapter 8 Problem 20 Key facts and assumptions concerning Kroger Company, at December 12, 2007, appear below. Using this information, answer the questions following. Facts and Assumptions Yield to maturity on long-term government bonds 4.54% Yield to maturity on company long-term bonds 6.32% Coupon rate on company long-term bonds 7.50% Market price of risk, or risk premium 6.30% Estimated company equity beta                1.05 Stock price per share $          25.97 Number of shares outstanding              681.2 million Book value of equity $           4,965 million Book value of interest-bearing debt $           6,674 million Tax rate 35.0% a. Estimate Kroger's cost of equity capital. b. Estimate Kroger's weighted-average cost of capital. Prepare a spreadsheet or table showing the relevant variables. Chapter 8 Problem 20 Key facts and assumptions concerning Kroger Company, at December 12, 2007, appear below. Using this information, answer the questions following. Facts and Assumptions Yield to maturity on long-term government bonds 4.54% Yield to maturity on company long-term bonds 6.32% Coupon rate on company long-term bonds 7.50% Market price of risk, or risk premium 6.30% Estimated company equity beta                1.05 Stock price per share $          25.97 Number of shares outstanding              681.2 million Book value of equity $           4,965 million Book value of interest-bearing debt $           6,674 million Tax rate 35.0% a. Estimate Kroger's cost of equity capital. b. Estimate Kroger's weighted-average cost of capital. Prepare a spreadsheet or table showing the relevant variables.

Explanation / Answer

a. Cost of Equity can be calculated using CAPM model, as below

Cost of Equity = Risk Free Rate + Beta * (Risk Premium)

Here

Risk Free Rate = Long Term Govy bond = 4.54%

Beta = 1.05

Risk Premium = 6.30%

So Cost of Equity = 4.54 + 1.05 * 6.30 = 11.16%

b. Cost of debt is coupon rate on the company's bonds = 7.50%

So WACC = We * Cost of Equity + Wd * Cost of Debt * (1-Tax Rate)

Here We is weightage of equity in company capital and Wdis weightage of debt in company capital

Total Capital Invested = 4965 + 6674 = 11639

We = 4965 / 11639 = 0.43

Wd = 6674 / 11639 = 0.57

So WACC = 0.43 * 11.16% + 0.57 * 7.50% * (1-35%)

= 4.76% + 2.80% = 7.56%

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