Question

Below is information regarding the capital structure of Micro Advantage Inc. On the basis of this information you are asked to respond to the following three questions:

Required:

1. Micro Advantage issued a $5,100,000 par value, 18-year bond a year ago at 97 (i.e., 97% of par value) with a stated rate of 8%. Today, the bond is selling at 105 (i.e., 105% of par value). If the firm’s tax bracket is 20%, what is the current after-tax cost of this debt?

2. Micro Advantage has $5,100,000 preferred stock outstanding that it sold for $22 per share. The preferred stock has a per share par value of $26 and pays a $5 dividend per year. The current market price is $32 per share. The firm’s tax bracket is 27%. What is the after-tax cost of the preferred stock?

3. In addition to the bonds and preferred stock described in requirements 1 and 2, Micro Advantage has 60,000 shares of common stock outstanding that has a par value of $10 per share and a current market price of $150 per share. The expected after-tax market return on the firm’s common equity is 15%. What is Micro Advantage’s weighted-average cost of capital (WACC)?

Answer 1

1. After Tax Cost of Debt

Interest Expense on Bond = 5,100,000*8% = 408,000

Tax Shield on Interest Expense = 408,000* 20% =81,600

After Tax Cost of Bond = 408,000- 81,600= 326,400

cost of Debt % = 6.4% (326,400/5,100,000*100)

2. Cost of Preferred stock

No of preferred stock issued = 5,100,000/26= 196,154

Dividend = 5 * 196,154= $980,770

Tax benefits not available to preferred stock

Cost of preferred stock = $980,770

cost of preferred stock % =19.23 % ( 980,770/5,100,000*100)

3. WACC

WACC= (weight of Debt* cost of Debt) + (weight of preferred stock*Cost of preferred stock) +(weight of common stock* cost of common stock)

weight of Debt = Market Value of Debt/ Total Market Value of Debt and Equity

Market Value of Debt = 105* 51,000=$ 5,355,000

Market Value of preferred stock= 32* 196,154=6,276,928

Market Value of common stock= 150* 60,000= $9,000,000

weight of Debt= 5,355,000/(5,355,000+6,276,928+9,000,000)* 100= 25.955%

Weight of preferred stock= 6,276,928/(5,355,000+6,276,928+9,000,000)*100=30.423%

weight of common stock= 9,000,000/(5,355,000+6,276,928+9,000,000)*100=43.622%

Weighted Average cost of capital =6.4 * 25.955% + 19.23*30.423%+15*43.622%= 14 %