Question

Gold Diggers, Inc. has 652,000 shares of common stock, currently trading at $90.52/share. The common stock of Gold Diggers, Inc. is expected to generate a dividend of $3.00/share next year, and it has a Beta calculated at 1.95. It also has 10,000 shares of preferred stock, trading at $120/share. The preferred stock pays dividends of 11%. Finally, Gold Diggers, Inc. has 57,000 bonds currently trading at $1020/bond. The coupon rate is 6%, and the bonds will mature in 8 years. Gold Diggers, Inc. expects its dividends to grow at a rate of 12%/year, and it is in a 21% tax bracket. It estimates that the risk free rate of return is 5.5% and the market rate of return is 12%. Calculate the WACC for Gold Diggers, Inc. Be sure to show all your work. NOTE: When calculating the cost of equity, compute the cost using the CAPM method and the DCF (Dividend Constant Growth Method) and average the two.

What is the numeric response?

Answer 1

WACC = (weight of debt * cost of debt) + (weight of preferred stock * cost of preferred stock) + (weight of equity * cost of equity)

market value of debt = 57,000 * $1,020 = $58,140,000

market value of preferred stock = 10,000 * $120 = $1,200,000

market value of equity = 652,000 * $90.52 = $59,019,040

total market value = $58,140,000 + $1,200,000 + $59,019,040 = $118,359,040

weight of debt = $58,140,000 / $118,359,040 = 0.491

weight of preferred stock = $1,200,000 / $118,359,040 = 0.010

weight of equity = $59,019,040 / $118,359,040 = 0.499

cost of debt = YTM of bond * (1 - tax rate)

YTM is calculated using RATE function in Excel with these inputs :

nper = 8 (8 years to maturity with 2 semiannual coupon payments each year)

pmt = 1000 * 6% (semiannual coupon payment = face value * annual coupon rate. this is a positive figure as it is an inflow to the bondholder)

pv = -1020 (current bond price =1020. this is a negative figure as it is an outflow to the buyer of the bond)

fv = 1000 (face value of the bond receivable on maturity. this is a positive figure as it is an inflow to the bondholder)

the RATE is calculated to be 5.68%. This is the semiannual YTM. To calculate the annual YTM, we multiply by 2. Annual YTM is 11.36%

cost of debt = YTM * (1 - tax rate)

cost of debt = 11.36% * (1 - 21%) ==> 8.98%

cost of preferred stock = dividend / current price =$11 / 120 = 9.17%

cost of equity (CAPM) = risk free rate + (beta * market risk premium)

cost of equity (CAPM) = 5.50% + (1.95 * (12% - 5.50%)) ==> 18.18%

cost of equity (Gordon model) = (next year dividend / current share price) + constant growth rate

cost of equity (Gordon model) = (($3.00 * 1.12) / $90.52) + 0.12 = 15.71%

cost of equity = average of two methods = (18.18 + 15.71) / 3 = 16.94%

WACC = (0.491 * 8.98%) + (0.010 * 9.17%) + (0.499 * 16.94%) ==> 12.95%