Question

Phillips Equipment has 80,000 bonds outstanding that are selling at par. Bonds with similar characteristics are yielding 7.5 percent. The company also has 750,000 shares of 7 percent preferred stock and 2.5 million shares of common stock outstanding. The preferred stock sells for $50 a share. The common stock has a beta of 1.34 and sells for $42 a share. The cost of equity is 14.06 percent. The corporate tax rate is 38 percent. What is the firm's weighted average cost of capital?

Answer 1

Debt:

Number of bonds outstanding = 80,000
Face Value = $1,000
Current Price = $1,000

Market Value of Debt = 80,000 * $1,000
Market Value of Debt = $80,000,000

Annual YTM = 7.500%

Before-tax Cost of Debt = 7.500%
After-tax Cost of Debt = 7.500% * (1 - 0.38)
After-tax Cost of Debt = 4.650%

Preferred Stock:

Number of shares outstanding = 750,000
Current Price = $50

Annual Dividend = 7.00% * $100
Annual Dividend = $7

Market Value of Preferred Stock = 750,000 * $50
Market Value of Preferred Stock = $37,500,000

Cost of Preferred Stock = Annual Dividend / Current Price
Cost of Preferred Stock = $7 / $50
Cost of Preferred Stock = 14.000%

Common Stock:

Number of shares outstanding = 2,500,000
Current Price = $42

Market Value of Common Stock = 2,500,000 * $42
Market Value of Common Stock = $105,000,000

Cost of Common Stock = 14.060%

Market Value of Firm = Market Value of Debt + Market Value of Preferred Stock + Market Value of Common Stock
Market Value of Firm = $80,000,000 + $37,500,000 + $105,000,000
Market Value of Firm = $222,500,000

Weight of Debt = $80,000,000 / $222,500,000
Weight of Debt = 0.35955

Weight of Preferred Stock = $37,500,000 / $222,500,000
Weight of Preferred Stock = 0.16854

Weight of Common Stock = $105,000,000 / $222,500,000
Weight of Common Stock = 0.47191

WACC = Weight of Debt * After-tax Cost of Debt + Weight of Preferred Stock * Cost of Preferred Stock + Weight of Common Stock * Cost of Common Stock
WACC = 0.35955 * 4.650% + 0.16854 * 14.000% + 0.47191 * 14.060%
WACC = 10.67%