Johnny Cake Ltd. has 10 million shares of stock outstanding selling at $20 per share and an issue of $50 million in 8%, annual coupon bonds with a maturity of 13 years, selling at 93.5% of par ($1000). If Johnny Cake's weighted average tax rate is 34%, its next dividend is expected to be $2.00 per share, and all future dividends are expected to grow at 5% per year, indefinitely, what is its WACC?

Question

Quizplus · Accepted Answer

First, let's calculate the cost of debt:

- The coupon payment is 8% of $1000 = $80 per bond per year. 
- Since the bonds are selling at 93.5% of par, the actual cost of the bond is 0.935 * $1000 = $935. 
- The yield to maturity is the rate at which the present value of the bond's cash flows (coupon payments and the final payment of $1000) equals the current market price of the bond. We can use a financial calculator to find that the YTM is approximately 8.81%.

Therefore, the after-tax cost of debt is:

After-tax cost of debt = YTM * (1 - tax rate)
After-tax cost of debt = 8.81% * (1 - 0.34)
After-tax cost of debt = 5.81%

Next, let's calculate the cost of equity using the CAPM:

Cost of equity = risk-free rate + beta * market risk premium
We're not given the risk-free rate or the market risk premium, but we can assume the risk-free rate is about 3% and the market risk premium is about 8%. 
We need to calculate the beta of Johnny Cake. Let's assume it's 1.2.

Cost of equity = 3% + 1.2 * 8%
Cost of equity = 12.6%

Next, let's calculate the weight of each component in the WACC:

Weight of debt = market value of debt / (market value of debt + market value of equity)
We're told that the market value of the bonds is $50 million. 
Weight of debt = $50 million / ($50 million + $200 million)
Weight of debt = 20%

Weight of equity = 1 - weight of debt
Weight of equity = 1 - 0.2
Weight of equity = 0.8

Finally, we can calculate the WACC:

WACC = weight of debt * cost of debt * (1 - tax rate) + weight of equity * cost of equity
WACC = 0.2 * 5.81% + 0.8 * 12.6%
WACC = 13.26%

Therefore, the answer is C.