Question

Tyson Corporation is considering investing in a project that will allow them to expand their sales in the new value add snack market of multiple countries. The firm needs an estimate of its cost of capital to evaluate this proposed project. The common stack is currently trading at $25.00 per share. The historical dividend record of the firm over the past 5 years shows payment of 1.4, 1.5, 1.65, 1.70, 1/75. The firm has a market beta of 1..4. The observed market risk premium is 6%with a risk-free rate of 3.2% provided by the long-term governemnt bonds. The firm also has an outstanding issue of corporate bond carrying a coupon rate of 5%, paying annual interest with a maturity of 25 years. The bond is trading in the market for $900. The firm is in a marginal tax rate of 20%. The firm also has an issue of preferred stock. The current market price of the preferred is $40/share and pays $4.00 per share dividend.

Compute the ost of equity using the dividend discount model as well as the CAPM. Estimate the cost of equity for the firm as an average of the two.

Compute the after tax cost of debt

compute the cost of preferred stock

If

Equity is 90000

Debt is 45000

preferred stack is 15000

what is the WACC

Answer 1

Cost of equity (using CAPM) = risk-free rate + beta*market risk premium = 3.2% + (1.4*6%) = 11.60%

Cost of equity (using DDM):

The question does not specify how to calculate the historical dividends growth rate. We will use CAGR for this purpose. (Note: if arithmetic average is taken then growth rate will be different.)

Dividends growth rate (g) = [(latest dividend/dividend before 5 years)^(1/5)] -1 = [(1.75/1.40)^(1/5)] -1 = 4.564%

D1 = D0*(1+g) = 1.75*(1+4.564%) = 1.8299

Cost of equity = (D1/P0) + g = (1.8299/25) + 4.564% = 11.883%

Average cost of equity (ke) = (11.60% + 11.883%)/2 = 11.742%

Cost of preferred stock (kps) = annual dividend/price = 4/40 = 10%

Cost of debt: FV = 1,000; PV = 900; PMT (annual coupon) = coupon rate*FV = 5%*1,000 = 50; N = 25, solve for RATE.

YTM = 5.76%

After-tax cost of debt (kd) = 5.76%*(1-20%) = 4.612%

WACC = sum of weighted costs of capital

Total capital (TC) = equity + preferred stock + debt = 90,000 + 15,000 + 45,000 = 150,000

Weight of equity = equity/TC = 90,000/150,000 = 0.60

Weight of preferred stock = preferred stock/TC = 15,000/150,000 = 0.10

Weight of debt = debt/TC = 45,000/150,000 = 0.30

WACC = (0.60*11.742%) + (0.10*10%) + (0.30*4.612%) = 9.429% or 9.43%