Question

AB Corporation currently has 40,000 of its 9.5% semi-annual coupon bonds outstanding (Par value = $1,000). The bonds will mature in 20 years and are currently priced at $1,280 per bond. The company has an issue of 1.2 million preferred shares outstanding with a market price of $10.95. The preferred shares offer an annual dividend of $1.05. The companyalso has 2.5 million shares of common stock outstanding with a price of $26.00 per share. The company is expected to pay a $2.50 common dividend one year from today, and that dividend is expected to increase by 5 percent per year forever. The company typically pays flotation costs of 2% of the price on all newly issued securities.  

If the company is subject to a 28 percent marginal tax rate, what is the company’s after-tax, flotation-cost adjusted weighted average cost of capital

Cost of Debt (in %)

Cost of preferred stock (in %)

Cost of common stock (in %)

WACC (in %)

Answer 1

WACC = sum of [weight of security*cost of security]

Cost of debt: FV (par value) = 1,000; PV (flotation adjusted current price) = -1,280*(1-2%) = -1,254.40; PMT (semi-annual coupon) = annual coupon*par value/2 = 9.5%*1,000/2 = 47.50; N (number of coupons to be paid) = 20*2 = 40, solve for RATE.

Semi-annual yield = 3.55%, so YTM = 3.55%*2 = 7.10%

After-tax cost of debt = YTM*(1-Tax rate) = 7.10%*(1-28%) =5.11%

Cost of preferred shares = annual dividend/current price*(1-flotation cost) = 1.05/(10.95*(1-2%)) = 9.78%

Cost of common stock = (D1/P0*(1-f)) + g where D1 (expected dividend) = 2.50; P0 (current price) = 26; f (flotation cost) = 2%; g (annual growth rate) = 5%

= (2.50/26*(1-2%)) + 5% = 14.81%

WACC calculation:

WACC = 10.46%