Question

KNF Company (KNFC) is considering a new project that involves the production of additional product for which cash out flows and inflows have already estimated. KNFC 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 KNFC's tax rate is 32 percent. What WACC should KNFC apply to this new project's cash flows if the project has the same risk as KNFC '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%