Assume JUP has debt with a book value of $20 million,trading at 120% of par value.The bonds have a yield to maturity of 6%.The firm has book equity of $20 million,and 2 million shares trading at $18 per share.The firm's cost of equity is 12%.What is JUP's WACC if the firm's marginal tax rate is 35%?

Question

Quizplus · Accepted Answer

1. Calculate cost of debt: 
Since the bonds are trading at 120% of par value, the market value of debt = 20 million x 1.2 = $24 million
Therefore, yield to maturity does not equal the cost of debt. Instead, we can calculate the cost of debt using the following formula:
Cost of debt = (Annual interest payment / Market value of debt) x (1 - Marginal tax rate)
Annual interest payment = 6% x $20 million = $1.2 million
Cost of debt = ($1.2 million / $24 million) x (1 - 0.35) = 4.68%

2. Calculate cost of equity:
Cost of equity = Risk-free rate + Beta x (Market risk premium)
Assume risk-free rate = 2.5% and market risk premium = 5%
Beta is not provided in the question, so we cannot calculate it. Instead, we can assume a beta for JUP based on the industry average, and use that to calculate the cost of equity. Alternatively, we can use the dividend discount model, the CAPM or the Fama-French model to estimate the cost of equity. For the sake of simplicity, let's assume beta = 1.2, then:
Cost of equity = 2.5% + 1.2 x 5% = 8%

3. Calculate WACC:
WACC = (Cost of debt x Book value of debt / Total capital) + (Cost of equity x Market value of equity / Total capital)
Total capital = Book value of debt + Market value of equity
Total capital = $20 million + (2 million x $18 per share) = $56 million
WACC = (4.68% x $20 million / $56 million) + (8% x $36 million / $56 million) = 8.76%

Assume JUP Has Debt with a Book Value of $20