Wright Express (WE)has a capital structure that's 30% debt and 70% equity. The firm 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 rate of 12% and a yield to investors of 12.4%. If the current risk-free rate is 7% and the expected market return is 14.5%, what is Wright's WACC if its beta is 1.2 and it is subject to a marginal tax rate of 40%.

Question

Quizplus · Accepted Answer

Step 1: Calculate the cost of debt
We are given that the coupon rate on the bonds is 12%. Since bonds are issued at par value, the yield to investors will also be 12%. Therefore, the before-tax cost of debt is:

Before-tax cost of debt = Yield to investors on bonds = 12%

Since interest expense is tax-deductible, we need to adjust the before-tax cost of debt for taxes. The company's marginal tax rate is 40%, so the after-tax cost of debt is:

After-tax cost of debt = Before-tax cost of debt x (1 - Marginal tax rate) = 12% x (1 - 40%) = 7.2%

Step 2: Calculate the cost of equity using the CAPM
We are given that the risk-free rate is 7%, the expected market return is 14.5%, and the company's beta is 1.2. Using the CAPM formula, we can calculate the cost of equity:

Cost of equity = Risk-free rate + Beta x (Expected market return - Risk-free rate)
= 7% + 1.2 x (14.5% - 7%)
= 15.4%

Step 3: Calculate the weighted average cost of capital (WACC)
We are given that Wright Express has a capital structure that is 30% debt and 70% equity. Using these weights, we can calculate the WACC as:

WACC = Weight of debt x Cost of debt x (1 - Marginal tax rate) + Weight of equity x Cost of equity
= 0.3 x 7.2% x (1 - 40%) + 0.7 x 15.4%
= 13.4%

Wright Express (WE)has a Capital Structure That's 30% Debt and 70