Question

Meacham Corp. wants to raise financing to purchase a competitor. It can issue 12 year bonds with a 9% annual coupon for $1090 and will incur debt flotation costs of $15 per bond.

The company can sell additional equity shares to the public for $30 per share and estimates its equity flotation costs will be $3 per share. Meacham paid a $4 per share dividend yesterday and expects is dividends to grow 7% annually. The company is targeting a capital structure of 40% debt and 60% common equity and has a 35% marginal tax rate.

Calculate the company's WACC.

Answer 1

Weight of equity = 1-D/A

Weight of equity = 1-0.4

W(E)=0.6

Weight of debt = D/A

Weight of debt = 0.4

W(D)=0.4

Cost of equity

As per DDM

Price-flotation cost = recent dividend* (1 + growth rate )/(cost of equity - growth rate)

27-3 = 4 * (1+0.07) / (Cost of equity - 0.07)

Cost of equity% = 22.85

Cost of debt

K = N

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

k=1

K =12

1090-15 =∑ [(9*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^12

k=1

YTM = 8.0045526078

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

After tax cost of debt = 8.0045526078*(1-0.35)

= 5.20295919507

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

WACC=5.2*0.4+22.85*0.6

WACC =15.79%