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?

Answer 1

Weighted Avg Cost of Capital (WACC) = Pretax Cost of Debt * (1 - Tax Rate) * Weight of debt + Weight of Equity * Cost of Equity

Cost of Equity

Based on the informtaion given in question, we would use constant growth dividend discount model for calculation of cost of equity. This model can be mathematically represented as:

D₁ = D₀ * (1 + g) = 1.593 * (1 + 4%) = $1.657

r = 8.60% --> Cost of Equity

Market value of Equity

Market Cap = No of Shares * Market price = $7,560,000

Cost of Debt

Cost of debt is the YTM of the existing issue. Exact calculation for YTM can be done only using financial calculator or Excel. For manual calculation, we will use approximation formula:

F = $1000, C = $70, n = 4.89 year, P = $990

Substituting values in formula above:

YTM (approx) = 7.241%

{Exact YTM calculation in Excel snapshot below:

}

Cost of Debt = 7.25% (using the exact number, if you don't have access to Excel, use the approx YTM}

Post tax cost of debt = 7.25% * (1 - 34%) = 4.64%

Market Value of Debt

Total Market value of debt= 990 * 6000 = $5,940,000

Total Value of Capital = $5,940,000 + $7,560,000 = $13,500,000

Weight of debt = 5,940,000/13,500,000 = 44%

Weight of debt = 7,560,000/13,500,000 = 56%

WACC = (44% * 4.64%) + (56% * 8.60%) = 6.86%