The B. B. Lean Co. has 1.4 million shares of stock outstanding. The stock currently sells for $20 per share. The firm’s debt is publicly traded and was recently quoted at 93 percent of face value.

Question

The B. B. Lean Co. has 1.4 million shares of stock outstanding. The stock currently sells for $20 per share. The firm’s debt is publicly traded and was recently quoted at 93 percent of face value. It has a total face value of $5 million, and it is currently priced to yield 11 percent.
The risk-free rate is 8 percent, and the market risk premium is 7 percent. You’ve estimated that Lean has a beta of .74. If the corporate tax rate is 34 percent, what is the WACC of Lean Co.?

Accepted Answer

We can first determine the cost of equity and the cost of debt. Using the SML, we find that the cost of equity is 8%+.74×7%=13.18%. The total value of the equity is 1.4 million×$20 $28 million. The pretax cost of debt is the current yield to maturity on the outstanding debt, 11 percent. The debt sells for 93 percent of its face value, so its current market value is .93×$5 million=$4.65 million. The total market value of the equity and debt together is $28 million+4.65 million=$32.65 million.
From here, we can calculate the WACC easily enough. The percentage of equity used by Lean to finance its operations is $28 million/$32.65 million=85.76%. Because the weights have to add up to 1, the percentage of debt is 1-.8576=14.24%. The WACC
is thus:

WACC=[latex](E/V)×R_{E}+(D/V)×R_{D}×(1-T_{C})[/latex]

=.8576×13.18%+.1424×11%×(1-.34)

=12.34%

B. B. Lean thus has an overall weighted average cost of capital of 12.34 percent.

Question 14.4: The B. B. Lean Co. has 1.4 million shares of stock outstandi...

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