Question

You are given the following information for Watson Power Co. Assume the company’s tax rate is 25 percent. Debt: 15,000 6.4 percent coupon bonds outstanding, $1,000 par value, 28 years to maturity, selling for 106 percent of par; the bonds make semiannual payments. Common stock: 480,000 shares outstanding, selling for $66 per share; the beta is 1.17. Preferred stock: 21,000 shares of 4.2 percent preferred stock outstanding, currently selling for $87 per share. The par value is $100 per share. Market: 5 percent market risk premium and 5.3 percent risk-free rate. What is the company's WACC?

Answer 1

Market Value of each capital Structure

Debt = $1,59,00,000 [15,000 x $1,060]

Preferred Stock = $18,27,000 [21,000 x $87]

Equity = $316,80,000 [480,000x $66]

Total Market Value = $4,94,07,000

Cost of Debt

Cost of Debt = Yield to Maturity (YTM)

Yield to Maturity [YTM] = Coupon Amount + [(Face Value – Bond Price) / Maturity Years] / [(Face Value + Bond Price)/2]

= [{$32.00 + [($1,000 – 1,060) / 56 Years)}] / [($1,000 + 1,060) / 2]

= 2.98%

Semiannual YTM = 2.98%

Annual YTM = 5.96% [2.98% x 2]

After Tax Cost of Debt = Bond’s YTM x [ 1 – Tax Rate]

= 5.96% x (1 – 0.25)

= 4.47%

Cost of Preferred Stock

Cost of Preferred Stock = [Preferred Dividend / Selling Price] x 100

= [$4.20 / 87.00] x 100

= 4.83%

Cost of Equity

Cost of Equity = Rf + [B x Risk Premium]

= 5.30% + [1.17 x 5%]

= 11.15%

Weighted Average Cost of Capital (WACC)

Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of Preferred stock x Weight of preferred stock] + [Cost of equity x Weight of Equity]

= [4.47% x (159,00,000 / 494,07,000)] + [4.83% x (18,27,000 / 494,07,000)] + [11.15% x (316,80,000 / 494,07,000)]

= 1.44% + 0.18% + 7.15%

= 8.77%

“Hence, The Weighted Average Cost of Capital (WACC) = 8.77%”