Question

Given the following information of JB Inc., Damieon is looking for some conditions of the company.

• A company has a target capital structure of 30% debt, 20% preferred stock, and 50% common equity.

• The company’s bonds with face value of $1,000 pay a 10% coupon (semiannual), mature in 15 years, and sell for $751.82.

• A company’s preferred stock is selling for $60. It pays a dividend of $4.50 per year and has a perpetual life.

• The company stock beta is 1.9.

• Risk-free rate is 10%, and market risk premium is 5%.

• The company is a constant-growth firm that just paid a dividend of $4, sells for

$52 per share, and has a growth rate of 4%.

• The company’s marginal tax rate is 30%.

Calculate the weighted average cost of capital (WACC).

Answer 1

i) Cost of bond = YTM

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

Here,

F (Face value) = $1,000

P (Price) = $751.82

n (period) = 15 years * 2 = 3

Tax rate = 30% or 0.30

Coupon = Face value * Coupon %

Coupon = $1,000 * 10% * 6/12 months = $30

Now,

YTM = ($30 + (($1,000 - $751.82) / 30)) / (($1,000 + $751.82) / 2)

YTM = ($30 + $8.27) / $875.91

YTM = $38.27 / $875.91

YTM (semi annual) = 0.0437

YTM (annually) = (1 + YTM semi annually)^n - 1

n (compounding per year) = 2

YTM (annually) = (1 + 0.0437)^2 - 1

YTM (annually) = 0.0893 or 8.93%

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

Cost of debt after tax = 0.0893 * (1 - 0.30)

Cost of debt after tax = 0.0625 or 6.25%

ii) Cost of preferred stock = Dividend / Price

Cost of preferred stock = $4.50 / $60

Cost of preferred stock = 0.0750 or 7.50%

iii) a) Cost of equity using capm :

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

Here, Rf (Risk free rate) = 10% or 0.10

Beta = 1.9

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

Now,

Cost of equity = 0.10 + (1.9 * 0.05)

Cost of equity = 0.10 + 0.095

Cost of equity = 0.195 or 19.50%

b) Cost of equity dividend growth model :

Cost of equity = (D1 / P) + g

Here,

g (Growth rate) = 4% or 0.04

D1 (Expected dividend) = Current dividend + growth

D1 = $4 + 4% = $4.16

P (Price) = $52

Now,

Cost of equity = ($4.16 / $52) + 0.04

Cost of equity = 0.12 or 12%

iv) Average cost of equity = (Cost of equity using capm + Cost of equity using dividend growth model)/2

Average cost of equity = (0.1950 + 0.12) / 2

Average cost of equity = 0.1575 or 15.75%

vi) Weighted average cost of capital (WACC) = (Weight of debt * Cost of debt after tax) + (Weight of preferred stock * Cost of preferred stock) + (Weight of equity * Cost of equity)

Here,

Weight of debt = 30% or 0.30

Weight of preferred stock = 20% or 0.20

Weight of equity = 50% or 0.50

Cost of debt after tax = 0.0625

Cost of preferred stock = 0.0750

Cost of equity = 0.1575

Now,

WACC = (0.30 * 0.0625) + (0.20 * 0.0750) + (0.50 * 0.1575)

WACC = 0.0188 + 0.0150 + 0.0788

WACC = 0.1126 or 11.26%