Question

You are given the following information concerning Parrothead Enterprises:

Debt:		10,900 7.4 percent coupon bonds outstanding, with 21 years to maturity and a quoted price of 108.75. These bonds pay interest semiannually.
Common stock:		320,000 shares of common stock selling for $66.40 per share. The stock has a beta of 1.05 and will pay a dividend of $4.60 next year. The dividend is expected to grow by 5.4 percent per year indefinitely.
Preferred stock:		9,900 shares of 4.7 percent preferred stock selling at $95.90 per share.
Market:		An expected return of 10.1 percent, a risk-free rate of 5.2 percent, and a 40 percent tax rate.

  
Calculate the WACC for Parrothead Enterprises.

Answer 1

Formula sheet

A1	B	C	D	E	F	G	H	I
2
3
4		Formula for WACC is given as:
5		WACC = r(E) × w(E) + r(P) × w(P)+r(D) × (1 – t) × w(D)
6		Where, r(E), r(P) and r(D) are cost of equity, preferred stock and cost of debt, w(E), w(P) and W(D)
7		are weight of equity, preferred stock and debt and t is the tax rate
8
9		Calculation of cost of debt of coupon bonds:
10		Cost of debt will be the yield to maturity of the bond can be calculated as follows:
11		Time to maturity	21	years
12		Semi-annual coupon rate	0.074
13		Par value	1000
14		Market Price	=D13*108.75%
15		Semi-annual coupon	=D13*D12/2
16		Semi-annual Period	=D11*2
17
18		Rate(nper,pmt,PV, [fv],type) function of excel can be used to find the yield to maturity as follows:
19		NPER	=D16
20		PMT	=D15
21		PV	=-D14
22		FV	=D13
23
24		Yield to maturity of the coupon bond is	=2*RATE(D19,D20,D21,D22)	=2*RATE(D19,D20,D21,D22)
25
26		Hence Cost of Debt is	=D24
27
28
29		Calculation of Cost of Equity:
30
31		Cost of equity can be calculated using dividend growth model as below:
32		Dividend next Year (Div 1)	4.6
33		Price	66.4
34		Growth rate	0.054
35		Floatation cost (F)	0
36		From Dividend growth model,
37		r(E) = (Div1/P*(1-F))+g
38
39		Cost of equity=	=(D32/D33*(1-D35))+D34	=(D32/D33*(1-D35))+D34
40
41		Hence cost of Equity as per Dividend growth model is	=D39
42
43		As Per CAPM, Expected rate of return can be calculated as
44		r(E) = rf + ?*(rm-rf)
45		Using the Following data
46		Beta (?)	1.05
47		Risk free rate ( rf )	0.052
48		Market rate of return (rm)	0.101
49
50		Expected rate of return can be calculated as follows:
51		Expected rate of return	= rf + ?*(rm-rf)
52			=D47+D46*(D48-D47)	=D47+D46*(D48-D47)
53
54		Hence Cost of Equity using CAPM is	=D52
55
56		Average cost of Equity	=(D41+D54)/2	=(D41+D54)/2
57
58
59		Calculation of cost of preferred stock:
60		Cost of preferred stock can be calculated as follows:
61		Par Value	100
62		Annual Dividend of preferred stock	=D61*4.7%
63		Current Price	95.9
64		Floatation cost (F)	0
65		Cost of preferred stock	=Dividend/Current Price*(1-F)
66		Cost of preferred stock	=D62/(D63*(1-D64))	=D62/(D63*(1-D64))
67
68		Hence Cost of Preferred Stock is	=D66
69
70		Calculation of weights:
71
72		Capital	Number of Security	Price	Market Value	Weight
73		Bonds	10900	=D14	=D73*E73	=F73/$F$76
74		Preferred Stock	9900	=D63	=D74*E74	=F74/$F$76
75		Common Stock	320000	=D33	=D75*E75	=F75/$F$76
76		Market Value of company			=SUM(F73:F75)
77
78		Calculation of WACC:
79
80		Source of capital	Capital Structure	Cost
81		Debt	=G73	=D26
82		Common Stock	=G75	=D56
83		Preferred Stock	=G74	=D68
84		Total	=SUM(D81:D83)
85		Tax Rate	0.4
86
87		WACC of the firm is	= r(E) × w(E) + r(P) × w(P)+r(D) × (1 – t) × w(D)
88			=D82*E82+D83*E83+D81*E81*(1-D85)	=D82*E82+D83*E83+D81*E81*(1-D85)
89
90		Hence WACC of the firm is	=D88
91