Question

You are given the following information concerning Black Hills Enterprises:

• Debt: There are 10,200 number of bonds outstanding with 7.2 percent coupon rate. It has 23 years to maturity and a quoted price of 107 percentage of the par value. These bonds pay interest semiannually.

• Common stock: 285,000 shares of common stock selling for $65.70 per share. The stock has a beta of .97 and will pay a dividend of $3.90 next year. The dividend is expected to grow by 5.2 percent per year indefinitely.

• Preferred stock: 9,200 shares outstanding paying $4.6 dividend. It is selling at $95.20 per share.

• Market: An expected return of 10.8 percent, a risk-free rate of 5.1 percent, and a 30 percent tax rate.

Calculate the WACC for Black Hills Enterprises. (Hint: use the cost of equity (R_E) as the average of both the RE using CAPM and DGM approaches) 

Answer 1

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

Calculation of weights:

Total market value of firm = market value of debt + market value of Preferred stock + market value of common stock

Market value of debt/preferred or common stock = no. of bonds/preferred or common stock outstanding*market price per bond or share of preferred or common stock

Total market value of firm = 10200*($1,000*107%) + 9,200*$95.20 + 285,000*$65.70 = $10,914,000 + $875,840 + $18,724,500 = $30,514,340

par value of coupon bonds are $1,000.

weight of debt = market value of debt/Total market value of firm = $10,914,000/$30,514,340 = 0.36

weight of Preferred stock = $875,840/$30,514,340 = 0.03

weight of common stock = $18,724,500/$30,514,340 = 0.61

cost of debt is yield to maturity or YTM. we can use financial calculator to calculate YTM.

Coupons are paid semi-annual. so maturity will be double and coupon will be half.

N = semi-annual maturity = 23*2 = 46; PV = current price of bond = -$1,000*107% = -$1,070, FV = par value = $1,000; PMT = semi-annual coupon = $1,000*(7.2%/2) = $36 > CPT= Compute > I/Y = YTM = 3.30%

PV needs to be entered as negative value because it's a cash outflow.

This YTM of 3.30% is semi-annual. we'll make it annual by 3.30%*2 = 6.60%.

After-tax cost of debt = YTM*(1-tax rate) = 6.60%*(1-0.30) = 6.60%*0.70 = 4.62%

Cost of Preferred stock = Dividend/current stock price = $4.6/$95.20 = 0.0483 or 4.83%

Cost of common stock using CAPM approach = risk-free rate + beta*(expected market return - risk-free rate) = 5.1% + 0.97*(10.8% - 5.1%) = 5.1% + 0.97*5.7 = 5.1% + 5.53% = 10.63%

Cost of common stock using DGM approach = (dividend next year/current share price) + indefinite dividend growth rate

Cost of common stock using DGM approach = ($3.90/$65.70) + 0.052 = 0.0593607305936073 + 0.052 = 0.1114 or 11.14%

average Cost of common stock of both approches = (10.63% + 11.14%)/2 = 21.77%/2 = 10.885%

WACC = 0.36*4.62% + 0.03*4.83% + 0.61*10.885% = 1.6632% + 0.1449% + 6.63985% = 8.45%

the WACC for Black Hills Enterprises is 8.45%.