Question

McKinsey and Sons has a target capital structure that calls for 50% debt, 10% preferred stock, and 40% common equity. The firm can issue new 10 year debt with an annual coupon of 9% for $968.606. The firm is in a 35% tax bracket. The firm's preferred stock sells for $80 per share and pays a dividend of $10 per share; however, the firm will only net $77 per share on the sale of new preferred stock. The firm's common equity sells for $45 per share. The firm recently paid a dividend of $2.00 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 11% per year. What is the firm's WACC?

Answer 1

Debt:

Face Value = $1,000
Current Price = $968.606

Annual Coupon Rate = 9%
Annual Coupon Rate = 9.00% * $1,000
Annual Coupon = $90

Time to Maturity = 10 years

Let annual YTM be i%

$968.606 = $90 * PVIFA(i%, 10) + $1,000 * PVIF(i%, 10)

Using financial calculator:
N = 10
PV = -968.606
PMT = 90
FV = 1000

I = 9.50%

Annual YTM = 9.50%

Before-tax Cost of Debt = 9.50%
After-tax Cost of Debt = 9.50% * (1 - 0.40)
After-tax Cost of Debt = 6.175%

Preferred Stock:

Net Price = $77
Annual Dividend = $10

Cost of Preferred Stock = Annual Dividend / Net Price
Cost of Preferred Stock = $10 / $77
Cost of Preferred Stock = 12.99%

Equity:

Current Price, P0 = $45
Recent Dividend, D0 = $2.00
Growth Rate, g = 11%

Cost of Equity = D0 * (1 + g) / P0 + g
Cost of Equity = $2.00 * 1.11 / $45 + 0.11
Cost of Equity = 15.93%

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 = 0.50 * 6.175% + 0.10 * 12.99% + 0.40 * 15.93%
WACC = 10.76%