Question

The Cullumber Products Co. currently has debt with a market value of $225 million outstanding. The debt consists of 9 percent coupon bonds (semiannual coupon payments) which have a maturity of 15 years and are currently priced at $1,423.92 per bond. The firm also has an issue of 2 million preferred shares outstanding with a market price of $13 per share. The preferred shares pay an annual dividend of $1.20. Cullumber also has 14 million shares of common stock outstanding with a price of $20.00 per share. The firm is expected to pay a $2.20 common dividend one year from today, and that dividend is expected to increase by 4 percent per year forever. If Cullumber is subject to a 40 percent marginal tax rate, then what is the firm’s weighted average cost of capital?

Answer 1

Answer:

Cost of debt:

Price = $1,423.92

Semiannual coupon = 1000 * 9%/2 =$45

Time to maturity = 15 * 2 = 30 semiannual periods

Semiannual yield = RATE (nper, pmt, pv, fv, type)

= RATE (30, 45, -1423.92, 1000, 0)

= 2.48%

Cost of debt = 2.48% * 2 = 4.96%

Cost of preferred share:

Cost of preferred share = annual dividend / Current price = 1.20 / 13 = 9.23%

Cost of common share:

Cost of equity = (Dividend next year / current price) + Dividend growth rate = 2.20 /20 + 4% = 15%

Capital structure:

Market value of debt = $225 million

Market value of preferred stock = 2 * 13 = $26 million

Market value of common shares = 14 * 20 = $280 million

Total capital = 225 + 26 + 280 = $531 million

WACC:

WACC = Cost of equity * Weight of equity + Cost of preferred stock * Weight of preferred stock + Cost of debt * (1 - Tax rate) * weight of debt

= 15% * 280 / 531 + 9.23% * 26 / 531 + 4.96% * (1 - 40%) * 225 / 531

= 9.62%

Firm’s weighted average cost of capital = 9.62%