Question 13.4: Assume the expected return on Target’s equity is 11.5%, and ...
Assume the expected return on Target’s equity is 11.5%, and the firm has a yield to maturity on its debt of 6%. Debt accounts for 18% and equity for 82% of Target’s total market value. If its tax rate is 35%, what is an estimate of this firm’s WACC?
PLAN
We can compute the WACC using Eq. 13.7. To do so, we need to know the costs of equity and debt, their proportions in Target’s capital structure, and the firm’s tax rate. We have all that information, so we are ready to proceed.
r_{wacc}=r_EE\%+r_D(1-T_C)D\% (13.7)
EXECUTE
r_{wacc} = r_EE\% + r_D(1 – T_C)D\%= (0.115) (0.82) + (0.06) (1 – 0.35) (0.18) = 0.101, or 10.1%
EVALUATE
Even though we cannot observe the expected return of Target’s investments directly, we can use the expected return on its equity and debt and the WACC formula to estimate it, adjusting for the tax advantage of debt. Target needs to earn at least a 10.1% return on its investment in current and new stores to satisfy both its debt and equity holders.