Question

A firm has determined its optimal capital structure, which is comprised of the following sources and target market value proportions:

            Source of capital             target market proportions

            Long term debt                      30%

            Preferred stock                     5

            Common stock equity             65

Debt: The firm can sell a 20-year, $1000 par value, 9 percent bond for $970. Interest is payable annually.

Preferred Stock: The firm has determined it can issue preferred stock at $65 per share. The stock will pay an $8.00 annual dividend.

Common Stock: The firm’s common stock is currently selling for $40 per share. The dividend expected to be paid at the end of the coming year is $3.00. Its dividend payments have been growing at a constant rate of 5%.

Additionally, the firm’s marginal tax rate is 40 percent.

What are the firm’s after-tax cost of debt, cost of preferred stock, cost of common stock, and the weighted average cost of capital? Please show work.

Answer 1

after tax cost of debt = YTM of bond * (1 - tax rate)

YTM is calculated using RATE function in Excel with these inputs :

nper = 20 (20 years to maturity with 1 annual coupon payment each year)

pmt = 1000 * 9% (annual coupon payment = face value * annual coupon rate. This is a positive figure as it is an inflow to the bondholder)

pv = -970 (current bond price. This is a negative figure as it is an outflow to the buyer of the bond)

fv = 1000 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)

The RATE is calculated to be 9.34%. This is the YTM.

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

after tax cost of debt = 9.34% * (1 - 40%) ==> 5.60%

cost of preferred stock = dividend / current price = $8 / $65 = 12.31%

cost of equity = (next year dividend / current share price) + constant growth rate

cost of equity = ($3 / $40) + 0.05 = 12.5%

WACC = (weight of debt * cost of debt) + (weight of preferred stock * cost of preferred stock) + (weight of common stock * cost of common stock)

WACC = (30% * 5.60%) + (5% * 12.31%) + (65% * 12.50%)

WACC = 10.42%