Question

D company's current share price is $20 and it is expected to pay a $1 dividend per share next year. After that, the firm's dividends are expected to grow at a constant rate of 4% per year.

1) what is an estimate of D's cost of capital? (hint: thinking about $1 dividend is D1 or D0 when you apply the formula)

2)D also has preferred stock outstanding that pays a $2 per share fixed dividend and the preferred stock is currently priced at $28, What is D's cost of preferred stock?

3) D has 5 million common shares outstanding and 1 million preferred shares outstanding, and its equity has a total book value of $50 million. Its liabilities have a market value of $20 million. If D's common and preferred shars are priced as in question 1 and 2, what is the market value of D's total assets? and what are the weights of common stock, preferred stock and debt respectively?

4) D faces a 40% tax rate and 6% pretax cost of debt. Given the information in questions 1 to 3 and your answers to those problems, what is D's WACC?

Answer 1

1). D's cost of Equity = (D₁/P₀)+g

Where, D₁ is the expected dividend to be paid next year

P₀ is current stock price

g is growth rate

Cost of equity = ($1/$20)+0.04

= 0.09 or 9%

2). Cost of preferred stock = D/P₀

Where, D is annual dividend

Cost of preferred stock = $2/$28

= 0.071429 or 7.1429%

3). Market value of common shares outstanding = 5 million*$20

= $100 million

Market value of Preferred shares outstanding = 1million*$28

= $28 million

Total value of shareholders' Equity = $100 million + $28 million = $128million

Since, Assets = Liabilities + Equity

Market value of Assets = Market value of Liabilities + Market value of Shareholders' Equity

= $20 million + $128 million

= $148 million

Weight of common stock = Value of Common stock/Value of total Assets

= $100 million / $148 million

= 0.67568

Weight of preferred stock = Value of preferred stock / Value of Total Assets

= $28 million / $148 million

= 0.18919

Weight of Debt = Value of Debt/ Value of Total Assets

= $20 million / $148 million

= 0.13514

4). WACC = Cost of equity* weight of Equity+ Cost of Debt* weight of Debt*(1-tax rate) +Cost of preferered stock*weight of Preferred stock

= 9*0.67568 + 6*0.13514*(1-0.40) + 7.1429*0.18919

= 6.08112 + 0.4865 + 1.35137

= 7.92%