Question

The book value of Polopony Express’s debt is $31 million but is currently trading for 95% of book value, and has a coupon rate of 5% and a yield to maturity of 4.3%. The 4,760,000 shares of stock are currently trading at $62.65 per share, and the next dividend has been declared to be $8.40. Dividends are expected to grow indefinitely at 2.4%. Preferred stock has 2,400,000 shares outstanding and is currently selling for $56 per share, and pays a dividend of $4.20 per year. If the average tax rate is 20% and the marginal rate is 33%. What is the firm’s weighted average cost of capital (WACC)?

Answer 1

• First we have to calculate the cost of each specific source of capital
• post tax cost of debt= pre tax cost (1- marginal tax rate) = 4.3(1-0.33) =2.88%
• using dividend discount model, cost of equity= D/P + g where D is the dividend declared, P is current price and g is growth rate
• =8.40/62.65 + 0.024= 0.1340 + 0.024=0.1581 or 15.81%
• cost of preference shares= annual dividend/ market price= 4.20/56=0.075 or 7.5%
• Now we need to calcculate the weights.The weights will be based on market value
• market value of debt= 31000000 * 95%= 29450000
• market value of equity= 4760000 * 62.65=298214000
• market value of pref shares= 2400000 * 56= 22400000
• total market value= 350064000
• So weights will be: for debt=29450000/350064000=0.09, for equity= 298214000/350064000=0.85 and pref= 22400000/350064000= 0.06. (note: total of weights should be 1)
• WACC =summation of cost of specific sour\ces of capital multiplied by weights
• = 0.09 * 2.88 + 0.85 * 15.81 +0.06 *7.5=14.15%

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