Question

Consider the following information for Watson Power Co.: Debt: 4,500 9 percent coupon bonds outstanding, $1,000 par value, 20 years to maturity, selling for 104 percent of par; the bonds make semiannual payments. Common stock: 103,500 shares outstanding, selling for $63 per share; the beta is 1.1. Preferred stock: 15,500 shares of 7.5 percent preferred stock outstanding, currently selling for $107 per share. Market: 10 percent market risk premium and 6.5 percent risk-free rate. Assume the company's tax rate is 34 percent. Find the WACC. Multiple Choice 11.74% 12.24% 12.01% 11.84% 12.9%

Answer 1

Answer is 11.84%

Debt:

Number of bonds outstanding = 4,500
Face Value = $1,000
Current Price = 104% * $1,000
Current Price = $1,040

Value of Debt = 4,500 * $1,040
Value of Debt = $4,680,000

Annual Coupon Rate = 9%
Semiannual Coupon Rate = 4.5%
Semiannual Coupon = 4.5% * $1,000
Semiannual Coupon = $45

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

Let semiannual YTM be i%

$1,040 = $45 * PVIFA(i%, 40) + $1,000 * PVIF(i%, 40)

Using financial calculator:
N = 40
PV = -1040
PMT = 45
FV = 1000

I = 4.289%

Semiannual YTM = 4.289%
Annual YTM = 2 * 4.289%
Annual YTM = 8.578%

Before-tax Cost of Debt = 8.578%
After-tax Cost of Debt = 8.578% * (1 - 0.34)
After-tax Cost of Debt = 5.661%

Preferred Stock:

Number of shares outstanding = 15,500
Current Price = $107
Annual Dividend = 7.50% * $100 = $7.50

Value of Preferred Stock = 15,500 * $107
Value of Preferred Stock = $1,658,500

Cost of Preferred Stock = Annual Dividend / Current Price
Cost of Preferred Stock = $7.50 / $107
Cost of Preferred Stock = 7.009%

Equity:

Number of shares outstanding = 103,500
Current Price = $63

Value of Common Stock = 103,500 * $63
Value of Common Stock = $6,520,500

Cost of Common Equity = Risk-free Rate + Beta * Market Risk Premium
Cost of Common Equity = 6.50% + 1.10 * 10.00%
Cost of Common Equity = 17.500%

Value of Firm = Value of Debt + Value of Preferred Stock + Value of Common Stock
Value of Firm = $4,680,000 + $1,658,500 + $6,520,500
Value of Firm = $12,859,000

Weight of Debt = $4,680,000 / $12,859,000
Weight of Debt = 0.3639

Weight of Preferred Stock = $1,658,500 / $12,859,000
Weight of Preferred Stock = 0.1290

Weight of Common Stock = $6,520,500 / $12,859,000
Weight of Common Stock = 0.5071

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 = 0.3639 * 5.661% + 0.1290 * 7.009% + 0.5071 * 17.500%
WACC = 11.84%