Question

Unbelievable Deals Inc. has the following capital structure and marginal tax rate of 38%. What is its WACC?

Debt:

100,000 coupon bonds

10-year maturity

Face value of $1,000

Semi-annual coupon rate of 8%

Bond price of $1,060

Common shares:

Risk-free rate = 5%

Expected market risk premium = 8%

Beta = 1.2

Number of common shares = 3,000,000

Common share price = $30

Preferred shares:

Par value = $95

Dividends = $12

Share price = $150

Number of preferred shares = 100,000

Answer 1

Face value of bond = 1000

Coupon payment = 0.08 * 1000 = 80 /2 = 40 ( since it is a semi annual bond, we divide by 2)

Price of bond = 1060

Number of periods = 10 * 2 = 20 ( since it is a semi annual bond we multiply by 2)

Before tax cost of debt using a financial calculator = 7.15%

keys to use in a financial calculator, 2nd I/Y = 2, PMT = 40, FV = 1000, PV = -1060, N = 20, CPT I/Y

After tax cost of debt = 0.0715 ( 1 - 0.38)

After tax cost of debt = 0.04433 or 4.433%

Cost of equity using CAPM model = risk free rate + beta ( market risk premium)

cost of equity = 0.05 + 1.2 ( 0.08)

cost of equity = 0.146 or 14.6%

Cost of preferred shares = dividend / share price

Cost of preferred shares = 12 / 150

Cost of preferred shares = 0.08 or 8%

Market value of debt = 100,000 * 1060 = 106,000,000

market value of equity = 3,000,000 * 30 = 90,000,000

market vakue of preferred shares = 100,000 * 150 = 15,000,000

total market value = 106,000,000 + 90,000,000 + 15,000,000 = 211,000,000

weight of debt = 106,000,000 / 211,000,000 = 0.5024

weight of equity = 90,000,000 / 211,000,000 = 0.4265

weight of preferred shares = 15,000,000 / 211,000,000 = 0.0711

WACC = weight of debt * cost of debt + weight of equity * cost of equity + weight of preferred shares * cost of preferred shares

WACC = 0.5024 * 0.04433 + 0.4265 * 0.146 + 0.0711 * 0.08

WACC = 0.022271 + 0.062269 + 0.005688

WACC = 0.090228 or 9.023%