Question

Gold Diggers, Inc. has 350,000 shares of common stock, currently trading at $26/share. The common stock of Gold Diggers, Inc. is expected to generate a dividend of $2.00/share next year, and it has a Beta calculated at 1.2. It also has 100,000 shares of preferred stock, trading at $50/share. The preferred stock pays dividends of 7%. Finally, Gold Diggers, Inc. has 30,000 bonds currently trading at $960/bond. The coupon rate is 5%, and the bonds will mature in 8 years.

Gold Diggers, Inc. expects its dividends to grow at a rate of 6%/year, and it is in a 34% tax bracket. It estimates that the risk-free rate of return is 3% and the market rate of return is 7%.

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.

Answer 1

Equity:

Number of Common Shares = 350000, Share Price = P0 = $ 26, Risk-Free Rate = Rf = 3%, Market Return = Rm = 7 and Beta = 1.2

Dividend Growth Rate = g = 6%, Expected Dividend = D1 = $ 2

Let the CAPM cost of equity be r1

r1 = Rf + Beta x (Rm - Rf) = 3 + 1.2 x (7-3) = 7.8 %

Let the cost of equity using Dividend Discount Model be r2

r2 = (D1/P0) + g = (2/26) + 0.06 = 0.13692 or 13.692 % ~ 13.7 %

Average Cost of Equity = ke = (r1 + r2) / 2 = 10.75 %

Equity Value = 350000 x 26 = $ 9100000 or $ 9.1 million

Debt: Number of Bonds = 30000, Bond Price = $ 960, Tenure = 8 years and Coupon Rate = 5%, Par Value = $ 1000 (assumed)

Annual Bond Coupon = 0.05 x 1000 = $ 50

Let the yield to maturity of the bond be y

Therefore. 960 = 50 x (1/y) x [1-{1/(1+y)^(8)}] + 1000 / (1+y)^(8)

Using EXCEL's Goal Seek Function to solve the above equation, we get:

y = 0.0563487 or 5.63487 % ~ 5.635%

Cost of Debt = kd = y = 5.635 %

Bond (Debt) Value = 960 x 30000 = $ 28800000 or $ 28.8 million

Preferred Stock: Dividend Rate = 7 %, Stock Value = $ 50 and let the par value be $ 100

Annual Dividend = 0.07 x 100 = $ 7

Cost of preferred stock = kp = 7/50 = 0.14 or 14 %

Number of Preferred Stock = 100000 and Preferred Stock Value = 50 x 100000 = $ 5000000 or $ 5 million

Total Firm Value = 9.1 + 28.8 + 5 = $ 42,9 million

Equity Proportion = E = 9.1 / 42.9 = 0.2121

Debt Proportion = D = 28.8 / 42.9 = 0.6713

Preferred Stock Proportion = P = 5/42.9 = 0.1166

Tax Rate = 34 %

Therefore, WACC = kd x (1-Tax Rate) x D + ke x E + kp x P = 5.635 x (1-0.34) x 0.6713 + 10.75 x 0.2121 + 14 x 0.1166 = 6.40911 % ~ 6.41 %