Question

You are given the following information for Watson Power Co. Assume the company’s tax rate is 25 percent.

Debt:	15,000 6.4 percent coupon bonds outstanding, $1,000 par value, 28 years to maturity, selling for 106 percent of par; the bonds make semiannual payments.
Common stock:	480,000 shares outstanding, selling for $66 per share; the beta is 1.17.
Preferred stock:	21,000 shares of 4.2 percent preferred stock outstanding, currently selling for $87 per share. The par value is $100 per share.
Market:	5 percent market risk premium and 5.3 percent risk-free rate.

Answer 1

WACC (Weighted average cost of capital) calculations:

i) Cost of debt = YTM after tax

YTM = (Coupon + ((F - M) / n)) / ((F + M) / 2)

Here,

F (Face value) = $1,000

M (Market price) = $1,000 * 106% = $1,060

Tax rate = 25% or 0.25

n (period) = 28 years * 2 = 56 semi annual period

Coupon (semi annual) = Face value * Coupon rate * 6/12 months

Coupon = $1,000 * 6.4% * 6/12 months = $32

Now put the values into formula,

YTM = ($32 + (($1,000 - $1,060) / 56)) / (($1,000 + $1,060) / 2)

YTM = ($32 - $1.07) / $1,030

YTM = $30.93 / $1,030

YTM (semi annual) = 0.0300

YTM (annually) = (1 + YTM semi annual)^2 - 1

YTM (annually) = (1 + 0.0300)^2 - 1

YTM (annually) = 0.0609

Cost of debt after tax = YTM annually * (1 - tax rate)

Cost of debt after tax = 0.0609 * (1 - 0.25)

Cost of debt after tax = 0.0457 or 4.57%

ii) Cost of preferred stock = Dividend / Price

Here,

Price = $87

Dividend = Par value * Rate

Dividend = $100 * 4.20% = $4.20

Now,

Cost of preferred stock = $4.20 / $87

Cost of preferred stock = 0.0483 or 4.83%

iii) Cost of equity using CAPM model :

Cost of equity = Rf + Beta * (Rm - Rf)

Here,

Rf (Risk free rate) = 5.3% or 0.053

Rm - Rf (Market risk premium) = 5% or 0.05

Beta = 1.17

Now,

Cost of equity = 0.053 + (1.17 * 0.05)

Cost of equity = 0.053 + 0.0585

Cost of equity = 0.1115 or 11.15%

iv) Weight of capitals :

Debt = 15,000 bonds * $1,060 = $1,59,00,000

Preferred stock = 21,000 shares * $87 = $18,27,000

Common shares = 4,80,000 shares * $66 = $3,16,80,000

Total capital = Debt + Preferred stock + Common shares

Total capital = $1,59,00,000 + $18,27,000 + $3,16,80,000

Total capital = $4,94,07,000

Now,

Weight of debt = Debt / Total capital

Weight of debt = $1,59,00,000 / $4,94,07,000 = 0.32

Weight of preferred stock = Preferred stock / Total capital

Weight of preferred stock = $18,27,000 / $4,94,07,000 = 0.04

Weight of common shares = Common shares / Total capital

Weight of common shares = $3,16,80,000 / $4,94,07,000 = 0.64

v) WACC = (Weight of debt * Cost of debt) + (Weight of preferred stock * Cost of debt after tax) + (Weight of common shares * Cost of equity)

Using the above calculated details,

WACC = (0.32 * 0.0457) + (0.04 * 0.0483) + (0.64 * 0.1115)

WACC = 0.0146 + 0.0019 + 0.0714

WACC = 0.0879 or 8.79%