Question

The following information is given about your company. The company needs raise new capital to expand its facilities. The company’s optimum capital structure has been 40% debt, 10% preferred stock and 50% equity. The company will maintain this capital structure in financing this expansion plan. Currently the company's common stock is traded at a price of $15.65 per share. The last dividend paid on the common stock was $1.25 per share. The company will grow at 6% constant rate for long time in the future. The company's preferred stock is selling at $85 and has a quarterly preferred dividend of $1.35. Flotation costs have been estimated at 8% on the common stocks and 5% on the preferred stocks. The company has some bonds with $1000 par value outstanding, the market price of the bonds is $1025, and the bonds have 14 years to maturity. The coupon rate on those bonds is 8% with semi-annual payments. The tax rate is 40%.

What is the WACC for this company if they will issue new common stocks and new preferred stocks?

Answer 1

WACC= K_d * W_d + K_e* W_e + K_p* W_p

Cost of common stock (K_e) = (D₁/NP)+g

Here D₁= D₀*(1+g)

D₁= 1.25 * (1+0.06)

D₁= 1.325

NP= net proceeds = P-FC

NP= 15.65 - (15.65*0.08)

NP= 15.65 - 1.252

NP= 14.398

g= 6% given in question

Putting this in equation K_e = (D₁/NP)+g

K_e = (1.325/14.398)+0.06

K_e= 0.15203 = 15.203%

Cost of preferred stock (K_p) = D/NP

D= 1.35 quarterly = 5.4 yearly (Hint: 1.35*4 = 5.4)

NP = P* (1-FC%)

NP= 85*(1-0.05)

NP= 80.75

Putting the values in the formula (K_p) = D/NP

K_p = 5.4/80.75

K_p = 0.06687 = 6.687%

Cost of Debt(K_d) = I%(1-T%)

For I% which is the yield of the bond, we need to use either the financial calculator of excel

use the function RATE in Excel and put FV=1000, PV = -1025, nper=14, PMT= 8%*1000= 80

The yield (I%)= 7.70%

Tax rate (T%)= 40%

Putting the values in equation (K_d) = I%(1-T%)

= 7.70%(1-40%)

K_d =4.6%

As given in the question the weight of capital are as follows

Weight of equity (W_e) = 50%

Weight of Preferred shares (W_p) = 10%

Weight of Debt (W_d) = 40%

and as we calculated

K_e= 15.203%

K_p = 6.687%

K_d =4.6%

Putting these values in the equation WACC= K_d * W_d + K_e* W_e + K_p* W_p

= 4.6%* 40% + 15.203%* 50% + 6.687%*10%

= 1.85% + 7.60% + 0.67%

WACC = 10.12%