Question

Your task is to find the cost of capital (WACC) for a company. The company has three sources of capital available. The marginal tax rate for the company is 35%.

Common stock: 100 000 shares outstanding with the book value of $20 but currently trading at P/B=2.0. One may apply CAPM to estimate the cost of equity. Inputs for estimations are: risk free rate 2.8%, market risk premium 10.0% and the stock beta is 1.20.

Debt: 2 000 discount bonds with $1 000 par value, with 4 year to maturity. Bonds currently offer 6% yield to bondholders.

Preferred stock: 14 000 shares outstanding with $90 market price and 7% yield.

Find the cost of each financing source, capital structure weights for each source and the WACC.

Answer 1

Common stock:
Cost of equity = Risk free rate + beta * market risk premium
= 2.8% + (1.20 * 10%)
= 2.8% + 12%
= 14.8%

Market price per equity share = P/B * Book value per share = 2 * $20 = $40

Market value of equity = 100,000 * $40 = $4,000,000

Debt:
Before tax cost of debt = 6%
After tax cost of debt = 6% * (1 - 35%) = 3.9%

Current price (PV)= FV / (1 + Interest rate)^Number of periods

= $1,000 / (1 + 6%)^4

=$792.09

Current price of bond = $792.09

Market value of 2000 bonds = 2,000 * $792.09 = $1,584,180.

Preferred stock:
Cost of preference share = 7%

Market value = Number of preference shares outstanding * Price per share
= 14,000 * $90
= $1,260,000

Capital structure weight:

Total market value = $4,000,000 + $1,584,180 + $1,260,000 = $6,844,180

Weight of equity = $4,000,000/$6,844,180 = 58.44%
Weight of debt = $1,584,180/$6,844,180 = 23.15%
Weight of preferred shares = $1,260,000/$6,844,180 = 18.41%

WACC = Sum of (weight * cost of capital)
= (58.44% * 14.8%) + (23.15% * 3.9%) + (18.41% * 7%)
= 8.6497% + 0.9029 + 1.2887
= 10.84%