Question

Consider the following information for Watson Power Co.:

  

Debt:		4,500 7 percent coupon bonds outstanding, $1,000 par value, 18 years to maturity, selling for 103 percent of par; the bonds make semiannual payments.
Common stock:		94,500 shares outstanding, selling for $56 per share; the beta is 1.16.
Preferred stock:		16,000 shares of 6.5 percent preferred stock outstanding, currently selling for $105 per share.
Market:		7.5 percent market risk premium and 6 percent risk-free rate.

  

Assume the company's tax rate is 34 percent.

     

Find the WACC.

Answer 1

Calculation of cost of debt:

FV = 1000
PV = 1000 * 103% = 1030
Nper = 18 * 2 = 36
PMT = 1000 * 7% / 2 = 35

Cost of debt can be calculated by using the following excel formula:
=RATE(nper,pmt,pv,fv)*2
=RATE(36,35,-1030,1000)*2
= 6.71%

After tax cost of debt = Before tax cost of debt * (1 - tax rate)
= 6.71% * (1 - 0.34)
= 4.43%

Calculation of cost of preferred stock:

Cost of preferred stock = Annual dividend / share price
= ($100 * 6.5%) / $105
= $6.5 / $105
= 6.19%

Calculation of cost of equity:

Cost of equity = Risk free rate + beta * market risk premium
= 6% + 1.16 * 7.5%
= 6% + 8.7%
= 14.70%

Total value of firm = (4500 * $1030) + (94,500 * $56) + (16,000 * $105) = $11,607,000

Weight of debt = (4500 * $1030) / $11,607,000 = 0.3993

Weight of equity = (94,500 * $56) / $11,607,000 = 0.4559

Weight of preferred stock = (16,000 * $105) / $11,607,000 = 0.1447

WACC = (Weight of debt * cost of debt) + (weight of preferred stock * cost of preferred stock) + (weight of equity * cost of equity)
= (0.3993 * 4.43%) + (0.1447 * 6.19%) + (0.4559 * 14.70%)
= 1.77% + 0.90% + 6.70%
= 9.37%

WACC = 9.37%