Reading Foods is interested in calculating its weighted average cost of capital (WACC). The company’s CFO has collected the following information:

• The target capital structure consists of 40 percent debt and 60 percent common stock.

• The company has 20-year noncallable bonds with a par value of $1,000, a 9 percent annual coupon, and a price of $1,075.

• Equity flotation costs are 2 percent.

• The company’s common stock has a beta of 0.8.

• The risk-free rate is 5 percent.

• The market risk premium is 4 percent.

• The company’s tax rate is 40 percent.

• The company plans to use retained earnings to finance the equity portion of its capital structure, so it does not intend to issue any new common stock.

What is the company’s WACC?

9.1

12.6

To calculate the weighted average cost of capital (WACC), you need to determine the cost of debt and the cost of equity and then combine them using the target capital structure.

1. Cost of Debt:
The cost of debt is the interest rate the company pays on its debt. To calculate it, we can use the formula for the yield to maturity (YTM) on the bonds:

YTM = (Annual Coupon Payment + (Par Value - Market Price) / Years to Maturity) / ((Par Value + Market Price) / 2)

In this case, the annual coupon payment is $1,000 * 9% = $90, the par value is $1,000, the market price is $1,075, and the years to maturity is 20.

YTM = ($90 + ($1,000 - $1,075) / 20) / (($1,000 + $1,075) / 2)

Calculate the YTM using the formula and you'll get the cost of debt.

2. Cost of Equity:
The cost of equity is the return required by shareholders to invest in the company. The formula to calculate the cost of equity is as follows:

Cost of Equity = Risk-Free Rate + Beta * Market Risk Premium

In this case, the risk-free rate is 5%, the beta is 0.8, and the market risk premium is 4%. Plug in these values to calculate the cost of equity.

3. Weighted Average:
Once you have calculated the cost of debt and the cost of equity, you need to weight them based on the target capital structure. The target capital structure consists of 40% debt and 60% common stock.

WACC = (Weight of Debt * Cost of Debt) + (Weight of Equity * Cost of Equity)

Plug in the respective values and calculate WACC based on the formula.

Note: Since there are no flotation costs mentioned for debt, we can assume there are none. Also, since the company plans to use retained earnings to finance the equity portion, there are no flotation costs for equity either.

By following these steps, you can calculate the company's WACC.