Question

The Banana Corp. An agriculture company needs to find its weighted average cost of capital to analyze an expansion project. The firm is currently financed with debt, preference capital and ordinary equity. The firm faces a company tax rate of 25%. The following information is available.

Debt: The firm currently has 20,000 bonds on issue. The current market value of each bond is $920 the before tax cost of issuing new bonds would be 6% per annum.

Preference Capital: The firm currently issued 500,000 preference shares. The fixed amount of preferred dividends is $4, and the value of each preferred share is $60.

Ordinary Capital: 2,000,000 ordinary shares are currently on issue and the current ordinary share price is $30 per share. The company beta is 1.3, the risk free rate of return is 2% and the market risk premium is 8%.

Given the above information, calculate the weighted average cost of capital for use in analyzing the company’s expansion project.

Answer 1

Debt:

Number of bonds outstanding = 20,000
Face Value = $1,000
Current Price = $920

Market Value of Debt = 20,000 * $920
Market Value of Debt = $18,400,000

Before-tax Cost of Debt = 6.00%
After-tax Cost of Debt = 6.00% * (1 - 0.25)
After-tax Cost of Debt = 4.500%

Preferred Stock:

Number of shares outstanding = 500,000
Current Price = $60
Annual Dividend = $4

Market Value of Preferred Stock = 500,000 * $60
Market Value of Preferred Stock = $30,000,000

Cost of Preferred Stock = Annual Dividend / Current Price
Cost of Preferred Stock = $4 / $60
Cost of Preferred Stock = 6.667%

Common Stock:

Number of shares outstanding = 2,000,000
Current Price = $30

Market Value of Common Stock = 2,000,000 * $30
Market Value of Common Stock = $60,000,000

Cost of Common Stock = Risk-free Rate + Beta * Market Risk Premium
Cost of Common Stock = 2.00% + 1.30 * 8.00%
Cost of Common Stock = 12.400%

Market Value of Firm = Market Value of Debt + Market Value of Preferred Stock + Market Value of Common Stock
Market Value of Firm = $18,400,000 + $30,000,000 + $60,000,000
Market Value of Firm = $108,400,000

Weight of Debt = $18,400,000 / $108,400,000
Weight of Debt = 0.16974

Weight of Preferred Stock = $30,000,000 / $108,400,000
Weight of Preferred Stock = 0.27675

Weight of Common Stock = $60,000,000 / $108,400,000
Weight of Common Stock = 0.55351

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 = 0.16974 * 4.500% + 0.27675 * 6.667% + 0.55351 * 12.400%
WACC = 9.47%