Assume that you have been hired as a consultant by CGT, a major producer of chem
ID: 2756934 • Letter: A
Question
Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.
Assets
$38,000,000
$101,000,000
$139,000,000
Liabilities and Equity
$10,000,000
$9,000,000
$19,000,000
$40,000,000
$59,000,000
$30,000,000
$50,000,000
$80,000,000
$139,000,000
The stock is currently selling for $11.75 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $1,000.00. The beta is 0.85, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.
What is the best estimate of the after-tax cost of debt?
4.26%
4.44%
4.09%
3.35%
4.35%
Current assets$38,000,000
Net plant, property, and equipment$101,000,000
Total assets$139,000,000
Explanation / Answer
Best Estimate of After tax cost of debt = 7.25%(1-0.4)
= 7.25%*0.6
= 4.35%
Calculation of Weighted Average Cost of Capital
Bonds with semiannual payments @4.35% = $400000000
Market value of equity = $117500000
Required rate of return on equity E(R) = RFR + stock (Rmarket – RFR)
= 5.50% + 0.85(14.50%-5.50%)
= 13.15%
Weighted Average Cost of capital ={[Equity/(Equity+debt)]*13.15%} + {[Debt/(Equity+debt)]*4.35%}
= {[117500000/(117500000+400000000)]*13.15%} + {[400000000/(117500000+400000000)]*4.35%}
= (0.227*13.15%) + (0.773*4.35%)
= 2.985% + 3.36%
= 6.35%
Weighted Average Cost of Capital = 6.35%