Question

The Pharoah Products Co. currently has debt with a market value of $275 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 $1,429.26 per bond. The firm also has an issue of 2 million preferred shares outstanding with a market price of $17 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 4 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. (Round intermediate calculations and final answers to 4 decimal places, e.g. 1.2514.)
Debt ______

Preferred Equity _______

Common Equity ________

Calculate the cost of debt. (Round intermediate calculations to 4 decimal places, e.g. 1.2514 and final answer to 2 decimal places, e.g. 15.25%.)

Cost of Debit _______ %

What is the firm’s weighted average cost of capital? (Round intermediate calculations to 4 decimal places, e.g. 1.2514 and final answer to 2 decimal places, e.g. 15.25%.)

WACC ______%

Answer 1

1) Calculate the weights

As per information below table is worked out

Market Value	No of Shares	Price	Amount $ (in millions)
MV of Debt			275
MV Of Preferred Stock	2.00	17	34
MV Of Common Stock	14.00	20	280
Total MV			589

Weight of Debt = MV Of DEBT/Total MV = 275/589 = 46.6893%

Weight of Preferred Stock = MV Of Preferred Stock/Total MV = 34/589 = 5.7725%

Weight of Common Stock = MV Of Common Stock/Total MV = 280/589 = 47.5382%

2) Cost of Debt

Cost of Debt = Effective Rate of Interest*(1-tax rate) = 9%(1-40%) = 9%*(60%) = 5.4%

3) WACC

First Cost of preferred stock and common stock needs to be computed.

Cost of Preferred Stock = Preference Dividend/ Market price per share.

= 1.2/17 =7.0588%

Cost of Common Stock = Dividend next year/Market price per share + Growth rate of Dividends

= 2.2/20+4%

=11%+4%

=15%

WACC = MV Weight of Debt x Cost of Debt+MV Weight of Preferred Stock x Cost of Preferred Stock+MV Weight of Common Stockx Cost of Common Stock

=46.6893%*5.4%+5.7225%*7.0588%+47.5382%*15%

= 2.5212%+0.4039%+7.1307%

=10.06%