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Calculating Starr Company’s Weighted Average Cost of Capital (WACC) Using Market Values of Debt and Equity

Calculating the Weighted Average Cost of Capital (WACC) for Starr Company is a crucial step in determining the company’s cost of capital, which is essential for evaluating potential investment projects and making strategic financial decisions. To calculate WACC, we need to estimate the market values and costs of each component of capital, which includes long-term debt and common equity. Let’s break down the calculation step by step.

Step 1: Estimating the Market Value of Debt

The market value of debt represents the current market price or the present value of all future cash flows associated with the debt. In this case, Starr Company has $54 million of long-term debt with a coupon rate of 6%, annual compounding, and 12 years to maturity. To estimate the market value of debt, we can use the present value formula for a bond:

Market Value of Debt = Annual Coupon Payment × [(1 – (1 + r)^(-n)) / r] + Face Value / (1 + r)^n

Where:

Annual Coupon Payment = $54 million × 6% = $3.24 million

r (yield to maturity) = 5% or 0.05

n (years to maturity) = 12

Face Value = $54 million

Market Value of Debt = $3.24 million × [(1 – (1 + 0.05)^(-12)) / 0.05] + $54 million / (1 + 0.05)^12 Market Value of Debt ≈ $54 million

So, the market value of debt is approximately $54 million.

Step 2: Estimating the Market Value of Equity

The market value of equity is the total market value of the company’s common stock. Starr Company has 22 million shares of common stock outstanding, and the current stock price is $34 per share.

Market Value of Equity = Number of Shares Outstanding × Stock Price Market Value of Equity = 22 million shares × $34 per share ≈ $748 million

Step 3: Estimating the Cost of Debt

The cost of debt is the interest rate the company pays on its debt. In this case, it’s the yield to maturity, which is 5%.

Step 4: Estimating the Cost of Equity

The cost of equity can be estimated using the Gordon Growth Model (Dividend Discount Model) since the company expects dividends to grow at a constant rate. The formula for the cost of equity is as follows:

Cost of Equity (Ke) = (Dividend / Current Stock Price) + Dividend Growth Rate

Where:

Dividend (D1) = $2.77 per share

Current Stock Price = $34 per share

Dividend Growth Rate = 2%

Cost of Equity (Ke) = ($2.77 / $34) + 0.02 ≈ 0.0812 or 8.12%

Step 5: Calculating the WACC

Now that we have the market values and costs of debt and equity, we can calculate the WACC using the formula:

WACC = (Weight of Debt × Cost of Debt) + (Weight of Equity × Cost of Equity)

First, we need to find the weights of debt and equity:

Weight of Debt = Market Value of Debt / (Market Value of Debt + Market Value of Equity) Weight of Debt = $54 million / ($54 million + $748 million) ≈ 0.0672 or 6.72%

Weight of Equity = Market Value of Equity / (Market Value of Debt + Market Value of Equity) Weight of Equity = $748 million / ($54 million + $748 million) ≈ 93.28%

Now, we can calculate the WACC:

WACC = (0.0672 × 0.05) + (0.9328 × 0.0812) WACC ≈ 0.00336 + 0.07566 WACC ≈ 0.07902 or 7.90%

Therefore, Starr Company’s Weighted Average Cost of Capital (WACC), using market values of debt and equity, is approximately 7.90%. This means that the company needs to earn at least this rate of return on its investments to satisfy its investors and maintain its value in the market.