Question

Jake's Sound Systems has 210,000 shares of common stock outstanding at a market price of $36 a share. Last month, Jake's paid an annual dividend in the amount of $1.593 per share. The dividend growth rate is 4%. Jake's also has 6,000 bonds outstanding with a face value of $1,000 per bond. The bonds carry a 7% coupon, pay interest annually, and mature in 4.89 years. The bonds are selling at 99% of face value. The company's tax rate is 34%. What is Jake's weighted average cost of capital?

Please show all work and formulas..

Answer 1

Debt:

Number of bonds outstanding = 6,000
Face Value = $1,000
Current Price = 99%*$1,000 = $990

Value of Debt = 6,000 * $990
Value of Debt = $5,940,000

Annual Coupon Rate = 7%
Annual Coupon = 7%*$1,000 = $70
Time to Maturity = 4.89 years

Let annual YTM be i%

$990 = $70 * PVIFA(i%, 4.89) + $1,000 * PVIF(i%, 4.89)

Using financial calculator:
N = 4.89
PV = -990
PMT = 70
FV = 1000

I = 7.25%

Before-tax Cost of Debt = 7.25%
After-tax Cost of Debt = 7.25% * (1 - 0.34)
After-tax Cost of Debt = 4.785%

Equity:

Number of shares outstanding = 210,000
Current Price, P0 = $36

Value of Common Stock = 210,000 * $36
Value of Common Stock = $7,560,000

Last Dividend, D0 = $1.593
Growth Rate, g = 4%

Cost of Common Equity = D0*(1+g) / P0 + g
Cost of Common Equity = $1.593*1.04 / $36 + 0.04
Cost of Common Equity = 8.602%

Value of Firm = Value of Debt + Value of Common Stock
Value of Firm = $5,940,000 + $7,560,000
Value of Firm = $13,500,000

Weight of Debt = $5,940,000/$13,500,000
Weight of Debt = 0.44

Weight of Common Stock = $7,560,000/$13,500,000
Weight of Common Stock = 0.56

WACC = Weight of Debt*After-tax Cost of Debt + Weight of Common Stock*Cost of Common Stock
WACC = 0.44 * 4.785% + 0.56 * 8.602%
WACC = 6.92%