Question

Use the following information on Filmore Corporation to calculate its WACC. 10,000 bonds with face value of $1,000 matures in 5 years, has 8% coupon rate, pays coupons semiannually, and currently sells for $1,050. 1,000,000 common shares sell for $40 per share. The dividend next year will be $2, and dividends are expected to grow at 6% constantly. It has no preferred stock. Its tax rate is 35%. What is Filmore Corporation's WACC? show the steps

Answer 1

The formula to calculate WACC is:

WACC = (E/V)*R_E + (D/V)*R_D*(1-t)

where, E = Market value of Equity, R_E = Cost of Equity

D = Market Value of Debt, R_D = Cost of Debt, t = tax rate

V = D+E

Market Value of Equity = E = No. of shares outstanding * price per share = 1000000*40 = 40000000

Price of a bond = 1050

Market value of Debt = D = 1050*10000 = 1050*10000 = 10500000

V = D+E = 10500000+40000000 = 50500000

Weights of Equity and Debt

Weight of Equity = E/V = 40000000/50500000 = 400/505 = 0.792079207920792

Weight of Debt = D/V = 10500000/50500000 = 105/505 = 0.207920792079208

Cost of Equity

Cost of Equity (R_E) can be calculated using the Gordon Growth Model, where the price of the stock is given by:

P = D₁/(R_E-g)

P = current price of the stock = $40

D₁ = Next year's Dividend = 2

R_E = Cost of Equity

g = constant growth rate of dividends = 6%

40 = 2/(R_E-6%)

R_E-6% = 2/40

R_E = 6% + 5% = 11%

Cost of Equity = R_E = 11%

Cost of Debt

Cost of Debt is the YTM of the Bond

Par value of the bond = 1000

Price of the bond = 1050

The bond pays semi-annual coupons. So, we will consider semi-annual timer periods, semi-annual coupon rate

Annual coupon rate = 8%

Semi-annual coupon rate = 8%/2 = 4%

Semi-annual coupon payment = 4%*1000 = 40

Time to maturity = 5 years

No. of semi-annual periods = 5*2 = 10

Semi-annual YTM can be calculated using ba ii plus calculator as shown below:

Inser the following in ba ii plus calculator:

N = 10

PV = -1050

PMT = 40

FV = 1000

CPT -> I/Y [Press CPT and then press I/Y]

We get, I/Y = 3.401766188

Note that this is the semi-annual YTM

Annual YTM = 3.401766188%*2 = 6.803532377%

Cost of Debt = Annual YTM = R_D = 6.803532377%

WACC

WACC = (E/V)*R_E + (D/V)*R_D*(1-t)

E/V = 0.792079207920792, R_E = 11%, D/V = 0.207920792079208, R_D = 6.803532377%, t = 35%

WACC = 0.792079207920792*11% + 0.207920792079208*6.803532377%*(1-35%) = 0.0871287128712871 + 0.00919487296469467 = 0.0963235858359818 = 9.63235858359818%

WACC = 9.63% (Rounded to two decimals)