Question

You are about to start to consider a batch of new capital budgeting projects. Before you begin, you need to estimate your company’s Weighted-Average-Cost-of-Capital (WACC). The firm operates in the 21% marginal tax bracket. There are four sets of liability holders on the balance sheet. Calculate the WACC including all four classes of liabilities.

There are 7,640,000 shares of common stock outstanding. These are trading at $36.94 per share. You have decided to use the Gordon Growth Model to estimate the return required by your firm’s shareholders. In the most recent annual report the earnings per share (EPS) were $2.65. You feel that it is reasonable to assume that earnings will grow at about 1.40% into the foreseeable future.

There is an issue of 3,282,000 shares of preferred stock. These securities promise an (perpetual) annual dividend of $1.85. The shares are currently trading for $24.27.

There is an issue of 115,000 coupon bonds, which have a face value of $1,000, pay 4.85% (annual) coupons, and mature in 14 years. The securities are currently trading for $985.15.

The firm also has 90 short-term commercial paper notes outstanding that have a face value of $500,000, and mature in 37 days. These are currently selling for $498,504.06.

Answer 1

To Calculate the WACC first we need to to calculae the Required rate for all four classes of Liabilites.

For Common Stock, as per gordon Growth Model

price= EPS*(1+ growth rate)/(Required rate- Growth rate)

36.94= 2.65*(1.014)/(Required Rate -0.014)

(Required Rate -0.014)=2.687/36.94

Required rate = 0.073+0.014= 0.087.

Required Rate= 8.7%

For Preferred Stock,

Price = Dividend/ Required rate

24.27= 1.85/ Required rate

Required rate= 1.85/24.27= 7.6%

For coupon Bond,

price of bond= Present value of annuity+ Present Value of terminal value

985.15= 48.5/(1+r)+48.5/(1+r)^2+48.5/(1+r)^3+48.5/(1+r)^4+48.5/(1+r)^5+48.5/(1+r)^6+48.5/(1+r)^7+48.5/(1+r)^8+48.5/(1+r)^9+48.5/(1+r)^10+48.5/(1+r)^11+48.5/(1+r)^12+48.5/(1+r)^13+1048.5/(1+r)^14

r= 5%

For cpmmercial paper note,

498504.06=500000/(1+r)^37/90

1+r= (500000/498504.06)^90/37

r =1.007-1= 0.7% per quarter, thus annual interest rate = 0.7*4= 2.8%

Now we need weight of all four liabilites.for that we need to calculate values of these four

Common Stock= 7640000*36.94=$282221600.00

Coupon Bond= 115000*1000= $115000000.00

Commercial Paper notes= $500000.00

Preferred stock = 3282000*24.27= $79654140.00

Total of all four = $477375740.00

Now weight of common stock = $282221600.00/$477375740.00 = 59.12%

weight of preferred stock = $79654140.00/$477375740.00 = 16.69%

weight of coupon Bond= $115000000.00/$477375740.00 = 24.09%

weight of commercial paper notes = $500000.00/$477375740.00 = 0.10%

WACC= Weight of commom stock* requuired return of common stock+Weight of preffered stock* requuired return of preferred stock+Weight of coupon Bond* requuired return of coupon bond*(1-tax rate)+ Weight of commercial paper notes* requuired return of commercial paper notes

= 0.5912*0.087+0.1669*0.076+0.2409*0.05*(1-0.21)+0.001*0.028

=7.4%