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Question: Kenny Electric Company's noncallable bonds were issued several years ago and now have 20 years to...

Kenny Electric Company's noncallable bonds were issued several years ago and now have 20 years to maturity. These bonds have a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation?

a. 4.58%

b. 4.35%

c. 4.83%

d. 5.33%

e. 5.08%

Perpetual preferred stock from Franklin Inc. sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC?

a. 8.72%

b. 10.22%

c. 9.08%

d. 9.44%

e. 9.82%

When working with the CAPM, which of the following factors can be determined with the most precision?

a. The beta coefficient, bi, of a relatively safe stock.

b. The most appropriate risk-free rate, rRF.

c. The market risk premium (RPM).

d. The beta coefficient of "the market," which is the same as the beta of an average stock.

e. The expected rate of return on the market, rM.

Bartlett Company's target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of common using reinvested earnings is 12.75%. The firm will not be issuing any new stock. You were hired as a consultant to help determine their cost of capital. What is its WACC?

a. 9.54%

b. 8.98%

c. 9.26%

d. 10.12%

e. 9.83%

Avery Corporation's target capital structure is 35% debt, 10% preferred, and 55% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of common from reinvested earnings is 11.25%, and the tax rate is 40%. The firm will not be issuing any new common stock. What is Avery's WACC?

a. 9.17%

b. 9.54%

c. 8.82%

d. 8.48%

e. 8.15%

Answer 1

1) Cost of debt = After tax YTM (yield to maturity)

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

Here,

F (Face value) = $1,000

P (Price) = $1,075

n (period) = 20 years * 2 = 40 semi annual period

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

Coupon = $1,000 * 9.25% * 6/12 months = $46.25

Tax rate = 40% or 0.40

Now put the values into formula,

YTM = ($46.25 + (($1,000 - $1075) / 40)) / (($1,000 + $1075)/2)

YTM = ($46.25 - $1.875) / $1,037.50

YTM = $44.375 / $1,037.50

YTM (semi annual) = 0.0428

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

n (no. Of compounding per year) = 2

YTM (annual) = (1 + 0.0428)^2 - 1

YTM (annual) = 0.0874

After tax cost of debt = Annual YTM * (1 - Tax rate)

After tax cost of debt = 0.0874 * (1 - 0.40)

After tax cost of debt = 0.0874 * 0.60

After tax cost of debt = 0.0524 or 5.24%

Answer : d) 5.33%

Note : Difference is answer is due to decimal rounding off.

2) Cost of preferred stock = Dividend / (Price * (1 - Flotation rate))

Here,

Dividend = $8.50

Price = $97.50

Flotation rate = 4% or 0.04

Now,

Cost of preferred stock = $8.50 / ($97.50 * (1 - 0.04))

Cost of preferred stock = $8.50 / ($97.50 * 0.96)

Cost of preferred stock = $8.50 / $93.60

Cost of preferred stock = 0.0908 or 9.08%

Answer : c) 9.08%

3) Answer : d) beta coefficient of the market which is same as beta of an average stock.

Reason : Working with CAPM beta can be determined with the most precision. As beta is calculated,

Beta = Covariance / Variance.

Beta is only relevant measure of stocks risk related to market ie. Stocks relative volatility.

Other factors in CAPM are not calculated with most precision such as risk free rate, market return & market risk premium.

4) WACC = (Weight of debt * After tax cost of debt) + (Weight of preferred * Cost of preferred) + (Weight of common stock * Cost of retained earnings)

Here

Weight of debt = 40% or 0.40

Weight of preferred = 15% or 0.15

Weight of common stock = 45% or 0.45

After tax cost of debt = 6% or 0.06

Cost of preferred = 7.5% or 0.075

Cost of retained earnings = 12.75% or 0.1275

Now put the values into formula,

WACC = (0.40 * 0.06) + (0.15 * 0.075) + (0.45 * 0.1275)

WACC = 0.024 + 0.0112 + 0.0574

WACC = 0.0926 or 9.26%

Answer : c) 9.26%

5) WACC = (Weight of debt * After tax cost of debt) + (Weight of preferred * Cost of preferred) + (Weight of common stock * Cost of retained earnings)

Here,

Weight of debt = 35% or 0.35

Weight of preferred = 10% or 0.10

Weight of common stock = 55% or 0.55

After tax cost of debt = Rate * (1 - Tax rate )

Rate = 6.50% or 0.065, Tax rate = 40% or 0.40

After tax cost of debt = 0.065 * (1 - 0.40) = 0.039

Cost of preferred = 6% or 0.06

Cost of retained earnings = 11.25% or 0.1125

Now put the values into formula,

WACC = (0.35 * 0.039) + (0.10 * 0.06) + (0.55 * 0.1125)

WACC = 0.0136 + 0.006 + 0.0619

WACC = 0.0815 or 8.15%

Answer : e) 8.15%

Note : Rate of debt given is before tax cost of debt.