Wright Express (WE) has a capital structure of 30% debt and 70% equity. WE is considering a project that requires an investment of $2.6 million. To finance this project, WE plans to issue 10-year bonds with a coupon interest rate of 12%. Each of these bonds has a $1,000 face value and will be sold to net WE $980. If the current risk-free rate is 7% and the expected market return is 14.5%, what is the weighted cost of capital for WE? Assume WE has a beta of 1.20 and a marginal tax rate of 40%.

Question

Quizplus · Accepted Answer

1. First, calculate the cost of debt:
Coupon rate = 12%
Net proceeds per bond = $980
Face value per bond = $1,000
n = 10 years
Using the formula: Cost of debt = Coupon rate x (1 - tax rate) x (Face value / Net proceeds) + (Annual interest / Net proceeds + Face value) / 2
Cost of debt = 12% x (1 - 40%) x ($1,000 / $980) + (($1,000 x 12%) / ($980 + $1,000)) / 2 = 7.32%

2. Next, calculate the cost of equity:
Beta = 1.20
Risk-free rate = 7%
Expected market return = 14.5%
Using the formula: Cost of equity = Risk-free rate + Beta x (Expected market return - Risk-free rate)
Cost of equity = 7% + 1.20 x (14.5% - 7%) = 15.4%

3. Calculate the weighted cost of capital:
Weighted cost of capital = Cost of debt x Weight of debt + Cost of equity x Weight of equity
Weight of debt = 30%
Weight of equity = 70%
Weighted cost of capital = 7.32% x 0.3 + 15.4% x 0.7 = 13.4%

Wright Express (WE) Has a Capital Structure of 30% Debt