Question

A company has a targeted capital structure of 50% debt and 50% equity. Bond (debt) with face value (or principal amount) of $1200.00 paid 12% coupon annually, mature in 20 years and sell for $950.90. The company’s stock beta is 1.4, the risk free rate is 9% and market risk premium is 6%. The company has a constant growth rate of 6% and a just paid dividend of $3 and sells at $32 per share. If the company’s marginal, tax rate is 35% calculate:

1. What is the WACC using DDM?

2. If the flotation cost of new equity is 10%. What will be the company’s cost new equity capital?  

3. What would be the company’s WACC using the new capital?

Answer 1

Answer to Requirement 1.

Debt:

Face Value = $1,200
Current Price = $950.90

Annual Coupon Rate = 12%
Annual Coupon = 12%*$1,200 = $144

Time to Maturity = 20 years

Let Annual YTM be i%

$950.90 = $144 * PVIFA(i%, 20) + $1,200 * PVIF(i%, 20)

Using financial calculator:
N = 20
PV = -1200
PMT = 144
FV = 950.90

I = 15.39%

Annual YTM = 15.39%

Before-tax Cost of Debt = 15.39%
After-tax Cost of Debt = 15.39% * (1 - 0.35)
After-tax Cost of Debt = 10.00%

Equity:

Expected Dividend (D1) = $3 * 1.06 = $3.18
Current Price (P0) = $32
Growth Rate (g) = 6%

Cost of Common Equity = D1 / P0 + g
Cost of Common Equity = $3.18 / $32 + 0.06
Cost of Common Equity = 15.94%

Weight of Debt = 0.50
Weight of Equity = 0.50

WACC = Weight of Debt*After-tax Cost of Debt + Weight of Common Stock*Cost of Common Stock
WACC = (0.50 * 0.1000) + (0.50 * 0.1594)
WACC = 12.97%

Answer to Requirement 2.

Expected Dividend (D1) = $3 * 1.06 = $3.18
Current Price (P0) = $32 – ($32 * 10%) = $28.80
Growth Rate (g) = 6%

Cost of Common Equity = D1 / P0 + g
Cost of New Common Equity = $3.18 / $28.80 + 0.06
Cost of New Common Equity = 17.04%

Answer to Requirement 3.

Weight of Debt = 0.50
Weight of Equity = 0.50

Cost of Debt = 10.00%
Cost of New Common Equity = 17.04%

WACC = Weight of Debt*After-tax Cost of Debt + Weight of Common Stock*Cost of Common Stock
WACC = (0.50 * 0.1000) + (0.50 * 0.1704)
WACC = 13.52%