A corporation has 60,000 shares of common stock outstanding at a market price of $24 per share

Finance Nov 03, 2020

A corporation has 60,000 shares of common stock outstanding at a market price of $24 per share. The firm has also 4,000 bonds outstanding currently selling for $960 each. The stock beta of the company is 1.25 and the market risk premium is 7.2%. The T-bill rate of return is 4.5%. Assume that the company’s cost of debt is 6% and the tax rate is 33%. Estimate the cost of capital.

Expert Solution

COST OF EQUITY = RISK FREE RATE + BETA x (MARKET RISK PREMIUM)

= 4.5% + 1.25 x (7.2%)

= 4.5% + 9%

= 13.5%

COST OF DEBT = COST OF DEBT x (1-TAX RATE)

= 6% x (1-0.33)

= 6% x 0.67

= 4.02%

TOTAL WORTH = 60,000 x 24 + 4,000 x 960

=1,440,000 + 3,840,000

= 5,280,000

WEIGHT OF DEBT = 3,840,000 / 5,280,000

= 0.73

WEIGHT OF EQUITY = 1 -0.73

= 0.27

WACC = 0.73 x 4.02% + 0.27 x 13.5%

= 2.93 + 3.64

= 6.57%

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