3 Margo Corporation is a major producer of lawn care product

3. Margo Corporation is a major producer of lawn care products. Its stock currently sells for $80 per share; there are 10.5 million shares outstanding. Margo also has 400,000 bonds outstanding ($1000 face value per bond). These 10-year bonds pay annually, have a current yield of 10% and trade at 90% of face value. The risk free rate is 8%, the market risk premium is 9%, and Margo has beta equal to 2, The corporate tax rate is 34%. Margo is considering expansion of its facilities. Use the SML to determine the cost of equity Compute the WACC for Margo. a. b.

Solution

Cost of equity using SML = Risk free rate + beta ( market risk premium)

Cost of equity using SML = 0.08 + 2 ( 0.09)

Cost of equity using SML = 0.26 or 26%

Before tax cost of debt = 10%

After tax cost debt = 0.1 ( 1 - 0.34)

After tax cost debt = 0.066 or 6.6%

Market value of shares = 10,500,000 * 80 = $840,000,000

Market value of bonds = 400,000 * ( 0.9 * 1000) = $360,000,000

Total market value = 840,000,000 + 360,000,000 = 1,200,000,000

Weight of shares = 840,000,000 / 1,200,000,000 = 0.7

Weight of bonds = 360,000,000 / 1,200,000,000 = 0.3

WACC = Weight of stock * cost of stock + weight of bonds * cost of bonds

WACC = 0.7 * 0.26 + 0.3 * 0.066

WACC = 0.182 + 0.0198

WACC = 0.2018 or 20.18%