Please compute the weighted average cost of capital (WACC) based on
the following information:
Beta coefficient for firm's stock=1.1
S&P 500 index return=15%
Dow Jones Industrial average return=12%
Corporate AAA rate bond return=8%
Treasury bill return=4.3%
Equity (on balance sheet)= $2,000,000
Debt(on balance sheet)= $3,000,000
Debt is currently priced at $950, annual coupon rate is 5%, paid
semi-anually, 5 years until maturity.
Tax rate=40%

Please show all work!!!!

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Request for Question Clarification by omnivorous-ga on 01 Dec 2003 07:52 PST

Pheifer --

You'll want to see my comments on question 282076 as well.  One issue
turns on whether you're adjusting debt or equity values to market.

A second turns on whether or not to discount the interest paid by the
cost-of-risk-free capital (T-bill rate).  It is the proper way to
adjust cash flows.  However, it's not commonly used in WACC
calculations in the real world because companies know that:
*  the impact is minor
*  costs of capital are approximations

What do you want to do?

Best regards,

Omnivorous-GA

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Clarification of Question by pheifer-ga on 01 Dec 2003 09:24 PST

Hi. I responded to the comment you made on the other WACC question and
I'm not sure which way it should be answered. That was however a
multiple choice question, but this one is not. I'm only in a beginning
Finance class so I'm sure it is the easier, and more commonly used
method. I hope this helps! Thankyou very much.

Pheifer --

In this problem we have both debt and equity from the balance sheet,
giving us our debt/equity ratios.  In this problem it's not necessary
to adjust the debt levels with the decline in bond prices -- we'll
adjust interest rates instead:

Debt: 60%
Equity: 40%


COST OF EQUITY
------------------------

A software company, Value Pro, has a clear definition of the steps to
equity valuation (and they use it in their financial software):
ValuePro
"The Cost of Equity"
http://www.valuepro.net/approach/equity/equity.shtml

Rerp = Rm - Rf

Where, 
Rerp = the equity risk premium of stocks
Rm = market returns for a diversified portfolio.  You'll want to use
the S&P500, as it's a broader measure than the 40 stocks in the
Dow-Jones industrial average.  An even  better index would be a
broader index that includes small capitalization firms (Wilshire
5000), as the smallest S&P500 company will have capitalization 50
times larger than the example.
Rf = risk-free rate, generally a treasury bill rate in finance problems.

So, the Rerp = 15% - 4.3% = 10.7%

The Capital Asset Pricing Model adjusts the cost of capital for risk,
a relatively new concept developed by William Sharpe in the 1960s:
Dow-Jones Asset Manager
"Revisiting the CAPM"
http://www.stanford.edu/~wfsharpe/art/djam/djam.htm

Rs = Rf + B * (Rerp)

Where,
Rs = return on a stock
Rf = risk-free (t-bill) rate
B = beta (volatility, measured in the market)
Rerp = the equity risk premium of stocks

Okay, so your cost of equity is:
Rs = 4.3% + 1.1 * 10.7%
Rs = 4.3% + 11.77% = 16.07%


COST OF DEBT
---------------------

Debt costs are 5% per year.  However, there are two factors that
change this: a change in interest rates (which has lowered the
company's bond price) and taxes.

Interest rates have risen since issuing the bonds -- pushing down the
par value.  Most companies adjust their costs of capital at least once
each year to reflect market rates: a $950 bond is now yielding
$50/$950 = 5.26%.

However, after the tax credit for interest paid, the after-tax rate is
0.6 * 5.25% = 3.16%


WACC
----------

Now it's just a matter of weighting the two costs to get WACC:
0.6 * 3.16% + 0.4 * 16.07% = 1.9% + 6.43% = 8.33%



Google search strategy:
beta + "cost of equity"

Best regards,

Omnivorous-GA