Question

Question 6

SmartCar Corporation has 1 million shares of common stock outstanding, 20,000 shares of preferred stock outstanding, and 40,000 corporate bonds outstanding. The common stocks sell for $25, with a market beta of 1.5. The corporate bonds sell for $950 and the current YTM is 5%. The preferred stock currently sells for $100, with an annual dividend payment of $8 per share. The risk-free rate is 2% and the market expected return is 8%. SmarCar’s corporate tax rate is 35%. What is SmartCar’s cost of capital?

Answer 1

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

MV of equity=25*1000000

=25000000

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

MV of Bond=1000*40000*0.95

=38000000

MV of Preferred equity=Price*number of shares outstanding

MV of Preferred equity=100*20000

=2000000

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

=25000000+38000000+2000000

=65000000

Weight of equity = MV of Equity/MV of firm

Weight of equity = 25000000/65000000

W(E)=0.3846

Weight of debt = MV of Bond/MV of firm

Weight of debt = 38000000/65000000

W(D)=0.5846

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

Weight of preferred equity = 2000000/65000000

W(PE)=0.0308

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (expected return on the market - risk-free rate)

Cost of equity% = 2 + 1.5 * (8 - 2)

Cost of equity% = 11

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

After tax cost of debt = 5*(1-0.35)

= 3.25

cost of preferred equity

cost of preferred equity = Preferred dividend/price*100

cost of preferred equity = 8/(100)*100

=8

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

WACC=3.25*0.5846+11*0.3846+8*0.0308

WACC =6.38%