Question

Y Company (Y) is considering a new project that involves the production of additional product for which cash out flows and inflows have already estimated.Y has 14 million shares of common stock outstanding, 900,000 shares of 9 percent preferred stock outstanding and 210,000 ten percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $34 per share and has a beta of 2.028125, the preferred stock currently sells for $80 per share, and the bonds have 17 years to maturity and sell for 91 percent of par. The return on market portfolio is 12.5 percent, T-bonds (risk free assets) are yielding 4.5 percent, and Y's tax rate is 32 percent. What WACC should Y apply to this new project's cash flows if the project has the same risk as Y 's typical project?

Answer 1

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

MV of equity=34*14000000

=476000000

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

MV of Bond=1000*210000*0.91

=191100000

MV of Preferred equity=Price*number of shares outstanding

MV of Preferred equity=80*900000

=72000000

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

=476000000+191100000+72000000

=739100000

Weight of equity = MV of Equity/MV of firm

Weight of equity = 476000000/739100000

W(E)=0.644

Weight of debt = MV of Bond/MV of firm

Weight of debt = 191100000/739100000

W(D)=0.2586

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

Weight of preferred equity = 72000000/739100000

W(PE)=0.0974

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (expected return on the market - risk-free rate)

Cost of equity% = 4.5 + 2.028125 * (12.5 - 4.5)

Cost of equity% = 20.73

Cost of debt

K = Nx2

Bond Price =∑ [(Semi Annual Coupon)/(1 + YTM/2)^k]     +   Par value/(1 + YTM/2)^Nx2

k=1

K =17x2

910 =∑ [(10*1000/200)/(1 + YTM/200)^k]     +   1000/(1 + YTM/200)^17x2

k=1

YTM = 11.1951426698

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

After tax cost of debt = 11.1951426698*(1-0.32)

= 7.612697015464

cost of preferred equity

cost of preferred equity = Preferred dividend/price*100

cost of preferred equity = 9/(80)*100

=11.25

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

WACC=7.61*0.2586+20.73*0.644+11.25*0.0974

WACC =16.41%