Question

Consider the following information for Evenflow Power Co., Debt: 5,000 7.5 percent coupon bonds outstanding, $1,000 par value, 20 years to maturity, selling for 104 percent of par; the bonds make semiannual payments. Common stock: 105,000 shares outstanding, selling for $61 per share; the beta is 1.18. Preferred stock: 15,500 shares of 6.5 percent preferred stock outstanding, currently selling for $106 per share. Market: 9 percent market risk premium and 6.5 percent risk-free rate. Assume the company's tax rate is 33 percent. Required: Find the WACC. (Do not round your intermediate calculations.)

Answer 1

In order to calculate WACC, we first need to calculate the cost of individual components - debt, common stock and preferred stock.

Cost of debt - In order to calculate the cost of debt, we first need to calculate the YTM of the bond issue. Assuming we are not allowed to use Excel or Financial calculator, we will use YTM approximation formula.

Mathematically,

F = $1000, P = $1040

n = 20 years --> 40 semi-annual periods (=20 * 2)

Coupon = 7.5% * 1000 = $75 coupon (annual) --> $37.5 (semi-annual)

Approx YTM = 3.578% --> Semi-annual

Approx YTM = 7.157% --> Annual

Using Excel, Annual YTM = 7.588% --> Will use this for WACC Calculation. In case, if you do not have Excel handy, use Approx YTM to get to approx WACC.

Cost of Common Stock - We would use Capital Asset Pricing Model, in order to calculate the cost of equity (which is equal to expected return on equity in CAPM)

Cost of Equity = Risk Free rate + Beta * market Risk Premium

Cost of Equity = 6.5% + (1.18 * 9%) = 17.12%

Cost of Preferred Stock - Cost of preferred stock = Annual dividend/Current Price

Annual dividend on preferred stock = 6.5% * $100 (where $100 is assumed to be par value of preferred stock) = $6.5

Cost of preferred stock = 6.5/106 = 6.132%

Market Value of Debt = 5000 * 1040 = $5,200,000

Market value of Common stock = 105,000 * 61 = $6,405,000

Market value of Preferred stock = 15,500 * 106 = $1,643,000

Weight of Debt = 5,200,000/(5,200,000+6,405,000+1,643,000) = 39.25%

Weight of Equity = 6405,000/(5,200,000+6,405,000+1,643,000) = 48.35%

Weight of Debt = 1,643,000/(5,200,000+6,405,000+1,643,000) = 12.40%

WACC Calculation

WACC = [Cost of Debt * (1 - Tax) * Weight of Debt] + [Cost of Common Stock * Weight of common stock] + [Cost of Preferred Stock * Weight of preferred stock]

WACC = [7.59% * (1 - 33%) * 39.25%] + [17.12% * 48.35%] + [6.13% * 12.40%]

WACC = 2.0% + 8.28% + 0.76% = 11.03%