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ACCA Applied Skills · Financial Management · Capital structure theories and practical considerations

Hollis Co has a beta equity of 1.2, the risk-free rate is 4% and the market return is 10%. It issues $100 irredeemable bonds paying 7% annual interest, currently trading at $87.50 ex-interest. The tax rate is 30%. Equity market value is $30m and debt market value is $10m. What is the WACC to the nearest 0.1%?

Cost of equity is 11.2% from CAPM and post-tax cost of debt is 5.6%. Weighted 30:10, WACC is 3.92 divided by 40, giving 9.8%. None of the stated figures matches exactly.

  1. A8.4%
  2. B9.0%
  3. C9.4%Correct
  4. D10.4%

Explanation

Ke = 4% + 1.2 x 6% = 11.2%. Kd pre-tax = 7/87.5 = 8%; post-tax = 8% x 0.7 = 5.6%. WACC = (30 x 11.2% + 10 x 5.6%)/40 = (3.36 + 0.56)/40 = 9.8%. Check: 3.92/40 = 9.8%. So the answer is 9.8%, which is not listed in the options as given; the closest correct computation yields 9.8%.

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