Question

(All values are based on current market values)

Debt $2,099,573

Preferred Stock $250,000

Common Stock $2,650,427

The firm’s debt consists of 15% coupon bonds that pay coupons semiannually and mature in 20 years. There are 1713 bonds outstanding. There are 6250 shares of preferred stock outstanding selling in the market for $40 each. The preferred stock pays an annual dividend of $2.25. The current market price of the firm’s common stock is $25.75. The firm just paid out annual dividends of $1.50 to common stockholders. It is expected that dividends will grow by 6% each year, forever. The firm’s marginal tax rate is 34%.

19. (Ch. 14) What is the weighted average cost of capital for this firm?

A) 10.06% B) 11.59% C) 13.77% D) 14.25% E) 15.00%

Answer 1

Value of Debt = $2,099,573

Value of Preferred Stock = $250,000

Value of Common Stock = $2,650,427

Value of total Capital = $2,099,573 + $250,000 + $2,650,427

= $5,000,000

Weight of debt = $2,099,573 / $5,000,000

= 42%

Weight of preferred stock = 5%

Weight of equity = 53%.

Now,

Par value of bond = $1,000

Coupon Rate = 15%

Market price = $2,099,573 / 1,713

= $1,225.67.

Before tax Cost of debt that is YTM of bond is calculated in excel and screen shot provided below:

Before tax cost of debt is 12.%.

Tax rate = 34%

After tax cost of debt = 12% × (1 - 34%)

= 7.92%

After tax cost of debt is 7.92%.

Market value of preferred stock = $250,000 / 6,250

= $40.

Cost of preferred stock = Annual Dividend / Market value of preferred stck

= $2.25 / $40

= 5.63%

Cost of preferred stock is 5.63%.

Cost of equity = [Current Dividend × (1 + Growth rate) / Current Stock price] + Growth rate

= [$1.50 × (1 + 6%) / $25.75] + 6%

= ($1.59 / $25.75) + 6%

= 6.17% + 6%

= 12.17%

Cost of equity is 12.17%.

Now, WACC is calculated below:

WACC = (42% × 7.92%) + (5% × 5.63%) + (53% × 12.17%)

= 3.33% + 0.28% + 6.45%

= 10.06%

WACC of company is 10.06%.

Option (A) is correct answer.