Question

You are given the following information concerning Really great Company Inc.:

Debt: 10,000 4.25 percent coupon bonds outstanding, with 10 years to maturity. The bonds provide investors 3% return (YTM).

Common stock: 400,000 shares of common stock selling for $42 per share. The stock has a beta of .90 and will pay a dividend of $3.5 next year. The dividend is expected to grow by 3 percent per year indefinitely.

Preferred stock: 10,000 shares of preferred stock with par value of $100 and 4% fixed dividend currently selling for $80 per share.

Additional information: Corporate tax rate is 35%

Calculate the WACC for the company.

Answer 1

K = N

Bond Price =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =10

Bond Price =∑ [(4.25*1/100)/(1 + 3/100)^k]     +   1/(1 + 3/100)^10

k=1

Bond Price = 1.1066

MV of equity=Price of equity*number of shares outstanding

MV of equity=42*400000

=16800000

MV of Bond=Par value*bonds outstanding*%age of par

MV of Bond=1000*10000*1.1066

=11066000

MV of Preferred equity=Price*number of shares outstanding

MV of Preferred equity=80*10000

=800000

MV of firm = MV of Equity + MV of Bond+ MV of Preferred equity

=16800000+11066000+800000

=28666000

Weight of equity = MV of Equity/MV of firm

Weight of equity = 16800000/28666000

W(E)=0.5861

Weight of debt = MV of Bond/MV of firm

Weight of debt = 11066000/28666000

W(D)=0.386

Weight of preferred equity = MV of preferred equity/MV of firm

Weight of preferred equity = 800000/28666000

W(PE)=0.0279

Cost of equity

As per DDM

Price= Dividend in 1 year/(cost of equity - growth rate)

42 = 3.5/ (Cost of equity - 0.03)

Cost of equity% = 11.33

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 3*(1-0.35)

= 1.95

cost of preferred equity

cost of preferred equity = Preferred dividend/price*100

cost of preferred equity = 4/(80)*100

=5

WACC=after tax cost of debt*W(D)+cost of equity*W(E)+Cost of preferred equity*W(PE)

WACC=1.95*0.386+11.33*0.5861+5*0.0279

WACC =7.53%