Question

Consider the following information for Watson Power Co.:

  

Debt:		4,500 8.5 percent coupon bonds outstanding, $1,000 par value, 20 years to maturity, selling for 102 percent of par; the bonds make semiannual payments.
Common stock:		103,500 shares outstanding, selling for $55 per share; the beta is 1.09.
Preferred stock:		13,500 shares of 7.5 percent preferred stock outstanding, currently selling for $104 per share.
Market:		10.5 percent market risk premium and 7.5 percent risk-free rate.

  

Assume the company's tax rate is 31 percent.

     

Find the WACC.

Multiple Choice

• 12.74%

• 12.34%

• 13.35%

• 12.24%

• 12.44%

Answer 1

Answer is 12.34%

Debt:

Number of bonds outstanding = 4,500
Face Value = $1,000
Current Price = 102% * $1,000
Current Price = $1,020

Value of Debt = 4,500 * $1,020
Value of Debt = $4,590,000

Annual Coupon Rate = 8.50%
Semiannual Coupon Rate = 4.25%
Semiannual Coupon = 4.25% * $1,000
Semiannual Coupon = $42.50

Time to Maturity = 20 years
Semiannual Period to Maturity = 40

Let semiannual YTM be i%

$1,020 = $42.50 * PVIFA(i%, 40) + $1,000 * PVIF(i%, 40)

Using financial calculator:
N = 40
PV = -1020
PMT = 42.50
FV = 1000

I = 4.147%

Semiannual YTM = 4.147%
Annual YTM = 2 * 4.147%
Annual YTM = 8.294%

Before-tax Cost of Debt = 8.294%
After-tax Cost of Debt = 8.294% * (1 - 0.31)
After-tax Cost of Debt = 5.723%

Preferred Stock:

Number of shares outstanding = 13,500
Current Price = $104
Annual Dividend = 7.50% * $100 = $7.50

Value of Preferred Stock = 13,500 * $104
Value of Preferred Stock = $1,404,000

Cost of Preferred Stock = Annual Dividend / Current Price
Cost of Preferred Stock = $7.50 / $104
Cost of Preferred Stock = 7.212%

Equity:

Number of shares outstanding = 103,500
Current Price = $55

Value of Common Stock = 103,500 * $55
Value of Common Stock = $5,692,500

Cost of Common Equity = Risk-free Rate + Beta * Market Risk Premium
Cost of Common Equity = 7.50% + 1.09 * 10.50%
Cost of Common Equity = 18.945%

Value of Firm = Value of Debt + Value of Preferred Stock + Value of Common Stock
Value of Firm = $4,590,000 + $1,404,000 + $5,692,500
Value of Firm = $11,686,500

Weight of Debt = $4,590,000 / $11,686,500
Weight of Debt = 0.3928

Weight of Preferred Stock = $1,404,000 / $11,686,500
Weight of Preferred Stock = 0.1201

Weight of Common Stock = $5,692,500 / $11,686,500
Weight of Common Stock = 0.4871

WACC = Weight of Debt * After-tax Cost of Debt + Weight of Preferred Stock * Cost of Preferred Stock + Weight of Common Stock * Cost of Common Stock
WACC = 0.3928 * 5.723% + 0.1201 * 7.212% + 0.4871 * 18.945%
WACC = 12.34%