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 market weights of capital structure?

29.73%

32.47%

26.95%

17.38%

19.54%

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%

Book Value of Preferred Stock ($100 par) = $ 20 million

No of Shares of Preferred Stock = $20 million/$100 = 200,000 shares

Market Value of Preferred Stock = 200,000 shares*$85

= $ 17,000,000

- 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%

Book Value of Equity Stock ($1 par) = $ 40 million

No of Shares of Equity Stock = $40 million/$1 = 40,000,000 shares

Market Value of Equity Stock = 40,000,000 shares*$3.25

= $ 130,000,000

- Before tax cost of debt = 14%

Book Value of Bonds ($1000 par) = $ 40 million

No of Shares of Bonds = $40 million/$1000 = 40,000 shares

Now calculating the Price of Bond:-

Semi-annual Coupon payment = $1000*12%*1/2 = $60

Semi-annual Yield (YTM) = 14%/2 =7%

Price = $ 744.54 + $ 131.37

Price = $ 875.91

Market Value of Bonds = 40,000 shares*$875.91

= $ 35,036,400

Total capital amount = $ 17,000,000 + $ 130,000,000 + $ 35,036,400

= $ 182,036,400

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 = (35,036,400/182,036,400)(14%)(1-0.30) + (130,000,000/182,036,400)(34.22%) + (17,000,000/182,036,400)(6.6873%)

WACC = 1.8862% + 24.4380% + 0.6245%

WACC = 26.95%

Hence, Option III

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