Question

A company’s Balance Sheet (in millions)

Assets                                                             Liabilities & Equity

Current                        $20              

Net Fixed                    $80                              Bonds ($1000 Par)                  40

                                                                        Preferred stocks ($100 Par)   20

Total                           $100                            Common Stock ($1 par)         40

                                                                        Total                                       $100

The company's bonds have 15 years to mature, pay 12% coupon rate semi-annually and comparable bonds' YTM is 14%.

The market price of the common stock is $3.25 per share. The most recent dividend on the common stock was $0.85.

The company’s applicable tax rate is 30%.

The common stock dividend has been growing steadily at 4% per year. The same growth rate is expected to continue for long time in the future.

The floatation cost for issuing new common stocks is 10%.

The market value of the preferred stock is $85 and it pays quarterly dividend of $1.35.

The floatation cost on issuing new preferred stock is 5%

Assume the company will issue new preferred stocks and new common stocks.

What is the WACC of the company using the book weights of capital structure?

		27.39%
		18.95%
		21.85%
		16.34%
		14.29%

Answer 1

  - Market Value of Preferred Stock = $ 85

Quarterly Dividend of Preferred Stock = $ 1.35

Annual Dividend = $ 1.35*4 = $ 5.4

Floatation cost on issuing new preferred stock is 5%

Cost of issuing new preferred stock = Dividend/Preferred Stock (1-Flotation cost)

= 5.4/85(1-0.05)

= 6.6873%

- Most recent dividend (D0) = $0.85

Constant growth rate (g) = 4% per year

Floatation cost for issuing new common stocks (F)= 10%.

market price of the common stock (P0) = $3.25 per share

Cost of Equity

  

= 34.22%

- Before tax cost of debt = 14%

Tax rate =30%

Calculating WACC based on book value weights:-

WACC= (Weight of Debt)(Cost of Debt)(1-Tax Rate) + (Weight of Common stock)(Cost of Equity) +(Weight of Preferred Stock)(Cost of Preferred Stock)

WACC = (40/100)(14%)(1-0.30) + (40/100)(34.22%) + (20/100)(6.6873%)

WACC = 3.92% + 13.688% + 1.33746%

WACC = 18.95%

Hence, Option II