Question

Very Busy Airlines has the following capital structure: Debt           $50,000,000 Preferred Stock       $10,000,000 Common Stock       $40,000,000 Additional info: Yield to maturity (bonds)   10% Price of preferred stock       $55 Price of common stock       $30 Preferred dividend       $10 Common dividend       $3 Flotation cost, preferred       $5 Growth rate of dividends   5% The firm’s tax rate is 40%. Compute the firm’s weighted average cost of capital [WACC]. (10) [Hint: First compute weights for debt, preferred stock, and common stock in the capital structure. Then compute their respective component costs. Finally compute the WACC].

Answer 1

Answer:

Value of Debt = $50,000,000

Value of Preferred Stock = $10,000,000

Value of Common Stock = $40,000,000

Total Value of firm = Value of Debt + Value of preferred stock + Value of common stock
Total Value of Firm = $50,000,000 + $10,000,000 + $40,000,000
Total Value of Firm = $100,000,000

Weight of Debt = $50,000,000/$100,000,000
Weight of Debt = 0.5

Weight of Preferred Stock = $10,000,000/$100,000,000
Weight of Preferred Stock = 0.1

Weight of Common Stock = $40,000,000/$100,000,000
Weight of Common Stock = 0.4

Before-tax Cost of Debt = 10%
After-tax Cost of Debt = 10% * (1 - 0.40)
After-tax Cost of Debt = 6%

Preferred Annual Dividend = $10

Cost of Preferred Stock = Preferred Annual Dividend / (Current Price – Flotation Cost)
Cost of Preferred Stock = $10 / ($55 - $5)
Cost of Preferred Stock = 20%

Cost of Common Equity = D1 / P0 + g
Cost of Common Equity = $3 / $30 + 0.05
Cost of Common Equity = 0.15 or 15%

WACC = Weight of Debt*After-tax Cost of Debt + Weight of Preferred Stock*Cost of Preferred Stock + Weight of Common Stock*Cost of Common Stock
WACC = 0.5*6% + 0.1*20% + 0.4*15%
WACC = 11%