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? You must show your work.
To calculate the weighted average cost of capital (WACC), we need to determine the cost of debt, cost of equity, and the weights of each component in the capital structure. The WACC formula is:
WACC = (W_d x r_d) + (W_e x r_e)
Where:
W_d = Weight of debt
r_d = Cost of debt
W_e = Weight of equity
r_e = Cost of equity
Now, let's calculate each component step by step:
1. Cost of Debt (r_d):
The cost of debt is the effective interest rate the company pays on its debt. In this case, the company has 20-year noncallable bonds with a 9% coupon and a price of $1,075. To calculate the cost of debt:
r_d = (Coupon Payment / Bond Price) x (1 - Tax Rate)
Coupon Payment = Coupon Rate x Par Value
Coupon Payment = 0.09 x $1,000 = $90
r_d = ($90 / $1,075) x (1 - 0.4)
r_d = 0.0837 or 8.37%
2. Weight of Debt (W_d):
The weight of debt represents the proportion of debt in the capital structure. In this case, the target capital structure is 40% debt and 60% equity. Thus:
W_d = 0.40 or 40%
3. Cost of Equity (r_e):
The cost of equity represents the required return on equity. It can be calculated using the Capital Asset Pricing Model (CAPM):
r_e = Risk-Free Rate + Beta x Market Risk Premium
Risk-Free Rate = 5%
Beta = 0.8
Market Risk Premium = 4%
r_e = 0.05 + 0.8 x 0.04
r_e = 0.05 + 0.032
r_e = 0.082 or 8.2%
Note: Since the company plans to use retained earnings to finance the equity portion, there are no flotation costs for equity.
4. Weight of Equity (W_e):
The weight of equity represents the proportion of equity in the capital structure. In this case, the target capital structure is 40% debt and 60% equity. Thus:
W_e = 0.60 or 60%
Now, we can calculate the WACC:
WACC = (W_d x r_d) + (W_e x r_e)
WACC = (0.40 x 0.0837) + (0.60 x 0.082)
WACC = 0.03348 + 0.0492
WACC = 0.08268 or 8.268%
Therefore, the company's weighted average cost of capital (WACC) is 8.268%.