Question

The Imaginary Products Co. currently has debt with a market value of $300 million outstanding. The debt consists of 9 percent coupon bonds (semiannual coupon payments) which have a maturity of 15 years and are currently priced at $915.93 per bond. The firm also has an issue of 2 million preferred shares outstanding with a market price of $29. The preferred shares pay an annual dividend of $1.20. Imaginary also has 14 million shares of common stock outstanding with a price of $20.00 per share. The firm is expected to pay a $2.20 common dividend one year from today, and that dividend is expected to increase by 6 percent per year forever. If Imaginary is subject to a 40 percent marginal tax rate, then what is the firm’s weighted average cost of capital?

Answer 1

Cost of debt:

Using financial calculator BA II Plus - Input details:	#
FV = Future Value =	-$1,000.00
PV = Present Value =	$915.93
N = Total number of periods = Number of years x frequency =	30
PMT = Payment = Coupon / frequency =	-$45.00
CPT > I/Y = Rate per period or YTM per period =	5.050
Convert Yield in annual and percentage form = Yield*frequency / 100 =	10.10%
Cost of debt = YTM x (1-Tax) =	6.06%

Cost of preferred:

Cost of preferred = Dividend / Market price of preferred

Cost of preferred = 1.20 / 29

Cost of preferred = 4.137931%

Cost of equity:

Given details	#
Existing growth rate = g =	6.00%
Expected dividend = D1 = D0*(1+g) =	2.20
Expected rate = r =	?
Flotation cost = f =	0.00
Current stock price = P0 =	20.00
Formula for calculating the Expected rate:
r = (D1/(P0-f))+g =	17.00%

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Weights of each types of capital:

Particulars	Price	Quantity	Price x Quantity	Market value Weight in decimal
Debt	$915.93	327,536	300,000,000.00	0.470219
Preferred Share	$29.00	2,000,000	58,000,000.00	0.090909
Equity	$20.00	14,000,000	280,000,000.00	0.438871
		Total	638,000,000.00

Weighted cost of capital calculation:

WACC = Cost of equity x Weight of equity + Cost of preferred x Weight of preferred + After tax Cost of debt x Weight of Debt

WACC = 17.00% x 0.438871 + 4.137931% x 0.090909 + 6.06% x 0.470219

WACC = 10.686520%

OR

WACC = 10.69%