Question

5. Find the WACC for Watson Power Co. given the following information and assuming a tax rate of 35%.

a. Debt: 10,000 bonds outstanding paying a 6.4% semi-annual coupon; $1,000 par value; 25 years remaining until maturity; the bonds are selling for 108% of par

b. Common: 495,000 shares outstanding selling for $63/share; beta = 1.15

c. Preferred: 35,000 shares paying a preferred dividend of $3.50/share and currently selling for $72/share

d. Market: 7% market risk premium; risk free rate = 3.2%

Answer 1

5. 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

Total market value of firm = 10,000*($1,000*108%) + 35,000*$72 + 495,000*$63 = $10,800,000 + $2,520,000 + $31,185,000 = $44,505,000

weight of debt = market value of debt/Total market value of firm = $10,800,000/$44,505,000 = 0.24

weight of Preferred stock = $2,520,000/$44,505,000 = 0.06

weight of common stock = $31,185,000/$44,505,000 = 0.70

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 = 25*2 = 50; PV = current price = -$1,000*108% = -$1,080, FV = par value = $1,000; PMT = semi-annual coupon = $1,000*(6.4%/2) = $32 > CPT= Compute > I/Y = YTM = 2.90%

This YTM of 2.90% is semi-annual. we'll make it annual by 2.90%*2 = 5.80%.

After-tax cost of debt = YTM*(1-tax rate) = 5.80%*(1-0.35) = 5.80%*0.65 = 3.77%

Cost of Preferred stock = Dividend/current stock price = $3.5/$72 = 0.0486 or 4.86%

Cost of common stock = risk-free rate + beta*market risk premium = 3.2% + 1.15*7% = 3.2% + 8.05% = 11.25%

WACC = 0.24*3.77% + 0.06*4.86% + 0.70*11.25% = 0.9048% + 0.2916% + 7.875% = 9.07%