RON Ltd has the following capital structure components: Five million shares issu

Question

RON Ltd has the following capital structure components:

Five million shares issued with a current market price of 11. Equity holders require a 8% return.

$10 million face value of Corporate bonds outstanding. These bonds pay an annual coupon of 6% and currently trade at a yield to maturity of 6%.

If the firm faces a corporate tax rate of 30%, compute RON Ltd's Weighted Average Cost of Capital (WACC). Enter your answer in decimal form to FOUR decimal places. For example 10.34%, would be entered as 0.1034

Explanation / Answer

Step 1:

1) Cost of Common Stock = 8%

2) Before Tax Cost of Debt = 6%

After Tax Cost of Debt = Before Tax Cost of Debt *(1-tax rate)

After Tax Cost of Debt = 6*(1-30%)

After Tax Cost of Debt = 4.20%

Step 2:

Market Value of Common Stock = 5Milion * 11 = $ 55 Million

Since Bond  annual coupon is equal to yield to maturity of 6%, Bond are trading at par

Market Value of Bond = $ 10 Million

Total Market Value = $ 65 Million

Weight of Common Stock = 55/65

Weight of Debt = 10/65

Step3:

WACC = Weight of Common Stock* Cost of Common Stock + Weight of Debt* After Tax cost of Debt

WACC = 55/65*8% + 10/65*4.2%

WACC = 0.0742

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