"Heart Limited has one bond in issue expiring in eight years, paying 0 coupon and has a face value of $1000. It is currently traded at $720, Beta =1.2, risk free rate is 2%, historic market risk premium is 5.5%. Assume the ratio of debt to equity is 2:1, and corporate tax rate is 20%." (c) Determine the WACC for Heart Limited.

Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
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"Heart Limited has one bond in issue expiring in eight years, paying 0 coupon and has a face value of $1000. It is currently traded at $720, Beta =1.2, risk free rate is 2%, historic market risk premium is 5.5%. Assume the ratio of debt to equity is 2:1, and corporate tax rate is 20%."

(c) Determine the WACC for Heart Limited.



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Hi, how do you derive to this formula? please enlighten, thankyou

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Calculation of cost of debt or yield to maturity;
Formula;
Cost of debt = (Z/P0)¹/n - 1
Cost of debt = ($1000/$720)1/8-1
Cost of debt = 1.388888888888890.125 - 1
Cost of debt = 1.04191775301815-1
Cost of debt = 0.04191775301815
Cost of debt = 4.191775301815%
Transcribed Image Text:个 Calculation of cost of debt or yield to maturity; Formula; Cost of debt = (Z/P0)¹/n - 1 Cost of debt = ($1000/$720)1/8-1 Cost of debt = 1.388888888888890.125 - 1 Cost of debt = 1.04191775301815-1 Cost of debt = 0.04191775301815 Cost of debt = 4.191775301815%
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Follow-up Question

Suppose Jack, president of Heart Limited has hired you to advise on the firm’s cost of capital. 

 

(a) Based on the most recent financial statements, Heart’s total liabilities are $8 million. Total interest expense for the coming year will be about $1 million. Jack therefore reasons, “We owe $8 million, and we will pay $1 million interest. Therefore, our cost of debt is obviously $1 million/8 million = 12.5%.” Appraise Jack’s statement.  

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Follow-up Question

(b) The company paid $1 million of dividends in the past year. Its market capitalization was $10 million. Based on his own analysis, Jack suggests that the company increases its use of equity financing, because “debt costs 12.5 percent, but equity only costs 10 percent; thus, equity is cheaper.” Appraise Jack’s statement. 

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