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Company X is calculating its WACC. The firm’s common stock just paid a dividend of $4.5...

Company X is calculating its WACC. The firm’s common stock just paid a dividend of $4.5 per share and now is selling for $80. The firm’s financial staff estimates the company’s new product will generate a dividend growth rate of 7%. Today the firm issued 7000 bonds that will mature in 15 years with $1,000 face value. These bonds will pay a 9% coupon rate quarterly and are currently selling for $970. The firm has 100K preferred shares of stock outstanding with a book value of $45, but currently selling for $55 per share. The last preferred dividend payments were $3.5 per share. The firm’s tax rate is 40%. The firm has 200K shares of common stock outstanding with the same book value as that of its preferred stock.

Calculate the book value weights for each source of capital.
Calculate the market value weights for each source of capital.
Calculate the before-tax and after tax componenet cost of capital
Determine the after tax weighted average costs of capital using both market and the book value weights.

Solutions

Expert Solution

Book value weights:

Book value of Debt = 7000 bonds x $1000 = $7,000,000

Book value of Common Stock = 200,000 shares x $45 = $9,000,000

Book value of Preferred stock = 100,000 shares x $45 = $4,500,000

Book value weight of Debt = $7,000,000 $20,500,000 = 34.15%

Book value weight of Common Stock = $9,000,000 $20,500,000 = 43.90%

Book value weight of Preferred Stock = $4,500,000 $20,500,000 = 21.95%

Market value weights:

Market value of Debt = 7000 bonds x $970 = $6,790,000

Market value of Common Stock = 200,000 shares x $80 = $16,000,000

Market value of Preferred stock = 100,000 shares x $55 = $5,500,000

Market value weight of Debt = $6,790,000 $28,290,000 = 24.00%

Market value weight of Common Stock = $16,000,000 $28,290,000 = 56.56%

Market value weight of Preferred Stock = $5,500,000 $28,290,000 = 19.44%

Before & After tax cost of debt

Cost of debt is nothing but YTM. It can be calculated using financial calculator

FV = 1000, PV = -970, PMT = 22.50 [90 4], N = 60 [15 x 4]

Compute I/Y

I/Y = 2.34%

Before tax cost of debt = 2.34% x 4 = 9.37% p.a.

After-tax cost of debt = 9.37% (1 - 40%) = 5.62% p.a.

Weighted Average Cost of Capital (WACC):

Book value:

WACC = Weight of common equity x Cost of common equity + Weight of preferred equity x Cost of preferred equity + Weight of debt x Cost of debt x (1 - tax rate)

Cost of preferred equity = Annual Dividends Current market price = $3.5 $55 = 6.36%

Cost of common equity = (Next year's dividend Current market price) + Growth Rate = [4.50 x (1 + 7%) 80] + 7%

Cost of common equity = 13.02%

WACC = 43.90% x 13.02% + 21.95% x 6.36% + 34.15% x 5.62% = 9.04%

Market Value:

WACC = 56.56% x 13.02% + 19.44% x 6.36% + 24.00% x 5.62% = 7.54%

jeff jeffy answered 1 year ago

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