Question

Divided Furniture Inc. has 11,000 bonds outstanding with a market price of $104 per bond. The firm also has 35,000 preferred shares outstanding and 45,000 common shares outstanding. Preferred stock and common stock are both expected to pay a year-end dividend of $2.20 per share. The current price per share of common stock is $36 per share. Preferred stock is priced at $52 per share. Preferred dividends do not grow and common stock dividends are expected to grow at a rate of 4 percent. The firm's tax rate is 40 percent. If the yield on the firm's bonds is 8%, what is the firm's weighted average cost of capital?

Answer 1

MV of equity=Price of equity*number of shares outstanding

MV of equity=36*45000

=1620000

MV of Bond=Par value*bonds outstanding*%age of par

MV of Bond=100*11000*1.04

=1144000

MV of Preferred equity=Price*number of shares outstanding

MV of Preferred equity=52*35000

=1820000

MV of firm = MV of Equity + MV of Bond+ MV of Preferred equity

=1620000+1144000+1820000

=4584000

Weight of equity = MV of Equity/MV of firm

Weight of equity = 1620000/4584000

W(E)=0.3534

Weight of debt = MV of Bond/MV of firm

Weight of debt = 1144000/4584000

W(D)=0.2496

Weight of preferred equity = MV of preferred equity/MV of firm

Weight of preferred equity = 1820000/4584000

W(PE)=0.397

Cost of equity

As per DDM

Price= Dividend in 1 year/(cost of equity - growth rate)

36 = 2.2/ (Cost of equity - 0.04)

Cost of equity% = 10.11

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

After tax cost of debt = 8*(1-0.4)

= 4.8

cost of preferred equity

cost of preferred equity = Preferred dividend/price*100

cost of preferred equity = 2.2/(52)*100

=4.23

WACC=after tax cost of debt*W(D)+cost of equity*W(E)+Cost of preferred equity*W(PE)

WACC=4.8*0.2496+10.11*0.3534+4.23*0.397

WACC =6.45%