The management of a local corporation believes there will be 3 states of the economy in the next year, along with their probabilities and rates of return.
Economy
|
Probability
|
Return
|
| Great | 0.4 | 0.16 |
| Average | 0.5 | 0.08 |
| Bad | 0.1 | -0.10 |
The corp has 15,000,000 common shares outstanding currently trading at $3 per share on the Nasdaq. The company also has bonds with a face value of $30,000,000 yielding a market rate of 7% and trading at 99. Given this above information, calculate the WACC. Assume a tax rate of 40%
Bond Calculations
|
Stock Calculations
|
| N =? I/Y = 7% (Rd) PV = 0.99 x 30,000,000 = 29,700,000 (D) FV = -30,000,000 | Re = Expected Return Great -> 0.4 x 0.16 = 0.064 Average -> 0.5 x 0.08 = 0.04 Bad -> 0.1 x -0.10 = -0.1 Re = 0.064 + 0.04 + -0.1 Re = 0.094 Total Equity = $3 x 15,000,000 Total Equity = $45,000,000 (1-t) = (1 - 0.4) = 0.6 |
Weighted Average Cost of Capital (WACC)
Formula
| [Rd x D/V x (1-T)] + [Re x E/V] |
Rd = Bond's yield to Maturity (I/Y in Calculator)
D = Market Value (Present Value) of Bonds
(1 - t) = 1 - tax rate = Interest tax shield deductibility of interest expense
Re = Shareholder's return requirement
V = Total value of all capital (Debt + Equity)
Summary of Important WACC
| Rd = 7% or 0.07 D = 29,700,000 (1-t) = 0.6 D / V = 29700 / 74,700 = 0.3976 | Re = 0.094 E = 45,000,000 V = 74,700,000 E/V = 45000 / 74700 = 0.6024 |
WACC = [Rd x D/V x (1-t)] + [Re x E/V]
WACC = [0.07 x 0.3976 x 0.6] + [0.094 x 0.6024]
WACC = 0.0166992 + 0.0566256
WACC = 0.0733248 -> 7.33%
Interpretation of WACC
A WACC of 7.33% means the local corp must earn a return of 7.33% on all its assets and business operations in order to MAINTAIN the current stock price at $3 per share. If the Corp. wants its stock price to go higher, it must achieve a return rate greater than 7.33%
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