Bolster Foods' (BF) balance sheet shows a total of $25 million long-term debt with a coupon rate of 8.50%. The yield to maturity on this debt is 8.00%, and the debt has a total current market value of $27 million. The balance sheet also shows that the company has 10 million shares of stock, and the stock has a book value per share of $5.00. The current stock price is $20.00 per share, and stockholders' required rate of return, rs, is 12.25%. The company recently decided that its target capital structure should have 35% debt, with the balance being common equity. The tax rate is 40%. Calculate WACCs based on book, market, and target capital structures, and then find the sum of these three WACCs.

Question

Quizplus · Accepted Answer

Firstly, let's calculate the cost of debt:

Cost of Debt = Yield to Maturity * (1 - Tax Rate)
Cost of Debt = 8.00% * (1 - 0.40)
Cost of Debt = 4.80%

a) Book Value Capital Structure:

Total Equity = Book Value per Share * Number of Shares = $5 * 10 million = $50 million
Total Capital = Total Debt + Total Equity = $25 million + $50 million = $75 million

Weight of Debt = Total Debt / Total Capital = $25 million / $75 million = 33.33%
Weight of Equity = Total Equity / Total Capital = $50 million / $75 million = 66.67%

WACC = (Weight of Debt * Cost of Debt) + (Weight of Equity * Required Rate of Return)
WACC = (0.3333 * 4.80%) + (0.6667 * 12.25%)
WACC = 9.82%

b) Market Value Capital Structure:

Total Equity = Stock Price * Number of Shares = $20 * 10 million = $200 million
Total Capital = Total Debt + Total Equity = $27 million + $200 million = $227 million

Weight of Debt = Total Debt / Total Capital = $27 million / $227 million = 11.89%
Weight of Equity = Total Equity / Total Capital = $200 million / $227 million = 88.11%

WACC = (Weight of Debt * Cost of Debt) + (Weight of Equity * Required Rate of Return)
WACC = (0.1189 * 4.80%) + (0.8811 * 12.25%)
WACC = 11.26%

c) Target Capital Structure:

Total Capital = $75 million / 0.35 = $214.29 million

Target Debt = 35% * $214.29 million = $75 million
Target Equity = $214.29 million - $75 million = $139.29 million

Weight of Debt = Target Debt / Total Capital = $75 million / $214.29 million = 34.98%
Weight of Equity = Target Equity / Total Capital = $139.29 million / $214.29 million = 65.02%

WACC = (Weight of Debt * Cost of Debt) + (Weight of Equity * Required Rate of Return)
WACC = (0.3498 * 4.80%) + (0.6502 * 12.25%)
WACC = 10.89%

Finally, we need to find the weighted average of the three WACCs based on the proportions of book, market, and target capital structures:

Weighted Average WACC = (0.4 * 9.82%) + (0.3 * 11.26%) + (0.3 * 10.89%)
Weighted Average WACC = 10.74%

Therefore, the correct answer is C (30.77%).

Bolster Foods' (BF) Balance Sheet Shows a Total of $25