Question

Information on Gerken Power Co., is shown below. Assume the company’s tax rate is 35 percent.

Debt:		9,500 9 percent coupon bonds outstanding, $1,000 par value, 25 years to maturity, selling for 99 percent of par; the bonds make semiannual payments.
Common stock:		220,000 shares outstanding, selling for $84.00 per share; beta is 1.25.
Preferred stock:		13,000 shares of 5.75 percent preferred stock outstanding, currently selling for $97.00 per share.
Market:		7% market risk premium and 4.8 percent risk-free rate.

Required:
Calculate the company's WACC. (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
  
WACC             %

Answer 1

Gerken Power Co.
Calculate the company's WACC.
KWACC = (WE x KE) + (WD x KDafter tax) + (WP x KP)
In which:
KWACC = Weighted average cost of capital
WE = Market value weight of Common Stock
KE = Cost of Equity (Common stock)
WD = Market value weight of Debt
KDafter tax = After-tax cost of debt
WP = Market value weight of Preferred Stock
KP = Cost of Preferred Stock
Market value of debt = 9,500 x ($1,000 x 99%)
	=	9,500 x $990
	=	94,05,000
Market value of common stock = 220,000 x $84
		=	18480000
Market value of preferred stock = 13,000 x $97
		=	1261000
Total market value of firm = Market value of debt +Market value of common stock + Market value of
preferred stock
		=	$9,405,000 + $18,480,000 + $1,261,000
		=	$29,146,000
Market value weight of Debt (WD) = Market value of debt / Total market value of firm
		=	$9,405,000 / $29,146,000
		=	0.322686
Market value weight of Common Stock (WE) = Market value of common stock / Total market value of firm
		=	$18,480,000 / $29,146,000
		=	0.634049
Market value weight of Preferred Stock (WP) = Market value of preferred stock / Total market value of firm
		=	$1,261,000 / $29,146,000
		=	0.043265
Before tax Cost of Debt (KD before tax) = ($45 x A.P.V.F50 R%) + ($1,000 / (1 + R%)50)
			= 4.55%
		YTM = 4.55% × 2 = 9.10%
And the aftertax cost of debt is:R D = (1 – .35)(.091) = 0.05914
The cost of preferred stock is:
R P = $5.75/$97
R P = 5.93%
Now we have all of the components to calculate the WACC. The WACC is:
WACC = 0.091(0.322686) + 0.1355(0.634049) + 0.0593(0.043265) = 0.117849 or 11.78%
Now, we can find the cost of equity using the CAPM. The cost of equity is:
R E = 0.0480 + 1.25(0.07) = 0.1355