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Computation of WACC

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					Question:

Common stocks of the Threes Company which currently has no debt in its capital structure are
trading for $50 a share. Threes has 2 million shares outstanding now. Threes Co. uses the CAPM
in estimating costs of capital. The (unlevered) equity beta for Threes Co. is 1.25, and the risk-
free rate and the market portfolio return are expected to be 5% and 13%, respectively. Its
income tax rate is 35%.

Mr. Jack Tripper, the Vice-President of Finance, is considering changing its financing policy to
actively maintain a target debt ratio of 20% (or 25% debt-to-equity ratio) of the levered firm. An
investment bank informed him that Threes may be able to issue 10-year $1,000 par bonds for
$922.05 per bond if it offers 4.0% annual coupons or for $1,116.92 per bond if it offers 6.5%
annual coupons. Coupons will be paid semi-annually. Threes plans to keep refinancing bonds at
maturity to effectively make bonds perpetual.

Compute: i) cost of equity at the target leverage ratio, ii) cost of debt, and iii) the WACC of the
Threes Co.

Solution:

Computation of cost of equity


Levered beta = Unlevered beta*[1+(1-tax rate)*Debt/Equity]
Unlevered beta                                      1.25
tax rate                                            35%
Debt/equity                                         25%
Unlevered beta                                      1.45
Risk free rate of return                            5%
Market return                                       13%
As per CAPM,
Cost of equity                                      16.63%
Computation of cost of debt


                                 Option 1          Option 2
Par value                        1000              1000
Issue price                      922.05            1116.92
Coupon rate                      4%                6.50%
Coupon paid                      20                32.5
No. of periods                   20                20
Tax rate                         35%               35%

Effective cost of debt           1.76%             1.44%
Annual cost of debt              3.55%             2.91%
Thus, the bond chosen will be
option 2
Cost of debt                                       2.91%


Computation of WACC


                              Equity        Debt
Cost                          16.63%        2.91%
Weight                        80%           20%
WACC                          13.88%

				
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