Question

The Pharoah Products Co. currently has debt with a market value of $200 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 $1,418.61 per bond. The firm also has an issue of 2 million preferred shares outstanding with a market price of $18 per share. The preferred shares pay an annual dividend of $1.20. Pharoah 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 Pharoah is subject to a 40 percent marginal tax rate, then what is the firm’s weighted average cost of capital?

Calculate the weights for debt, common equity, and preferred equity.

Calculate the cost of debt.

Calculate the cost of preferred equity.

Calculate the cost of common equity.

What is the firm’s weighted average cost of capital

Answer 1

Market value of Debt =200 million
Market value of Preferred Stock =Number of Shares *Share price of Preferred Stock =2 *18 =36 million
Market Value of Equity =Number of Shares *Share price of Stock =14 *20 =280 million
Total value =200+36+280 =516

Weights of Debt =200/516 =38.7597% or 38.76%
Weight of Common Equity =280/516=54.2636% or 54.26%
Weight of Preferred Stock =36/516 =6.9767% or 6.98%

Coupon =9%*1000/2 =45
Number of Periods =15*2 =30
PV =1418.61
Cost of Debt using excel formula =2*RATE(45,30,-1418.61,1000)=3.3391% or 3.34%
After tax Cost of Debt =3.3391%*(1-40%) =2.0035% or 2%
Cost of Preferred Stock =Annual Dividend/Price =1.20/18 =6.67%
Cost of Common equity =Dividend Next Year/Price + Growth) =2.20/20+6% =17%

WACC =Weight of Equity*Cost of Equity+Weight of Preferred Stock*Cost of Preferred Stock+Cost of Debt*Weight of Debt =
54.2636%*17+6.9767%*6.67%+38.7597%*2.0035% =10.47%