Question

Mutton Motors wants to build a new factory. They know the cost to build the factory and have forecasted the future cash flows from the plant. They want to do an NPV analysis but are not sure what rate to use. They come to you as a consultant to figure out their cost of capital. The information they have given you is: They just paid a dividend of $2.75. Their dividend growth rate is 4.8%. Their current stock price is $32.00, and they have 1,808,000 shares outstanding. They also have a beta of 1.16, the risk free rate is 3.01%, and the market risk premium is 5.24%. They have 11,000 bonds outstanding with a coupon rate of 4.5%, 14 years to maturity, a face value of $1000 and a market price of $1,100. They are semiannual bonds.

What is the debt to equity ratio?

What is the WACC?

If you had to calculate the cost of equity for Twitter, Inc. which way would you have to do it?

If a firm's WACC is 8.00%, what does this mean to the firm?

Answer 1

Debt = No of Bonds *Market Value of Bond = 11000*1100 = $12,100,000 (D)
Equity = No of shares * Current stock price = 1808000 * 32 =$57,856,000 (E)
Debt/Equity = 12,100,000/57,856,000 =0.209

Current Dividend D₀ = 2.75 Growth of Divident (g) = 4.8%, Current Price of Stock P = $32.00
Formula for Cost of Equity Ke = D₀ (1+g)/(P) + g = (2.75 * ( 1+ 0.048)/32) +0.048= 0.138 or 13.8%(Dividend growth method)
R_f = 3.01%, R_p = 5.24%, = 1.16
Under Capm Method Ke = R_f + * R_p = 3.01% + 1.16 * 5.24% = 9.0884%
Face Value of Bond = 1000 (FV)
Market value of Bond =1100 (PV)
Coupon rate = 4.5%
Time to Maturity (T) = 14 Yrs (t)
Using below formula we can get R_d = 1.79% (using formula at the bottom)
WACC = W_{d *} R_d + We * R_e = D/(D+E) * R_d + E/(D+E) * R_e = 0.173 * 1.79% + 0.827 * 9.0884% = 7.81%( Taking R_e from CAPM model)
For measuring WACC of Twitter inc Cost of equity should be calculated with CAPM method as dividend growth cannot bne predicted in Twitter.
WACC 8% means the avreage rate of return from debt, preferred stock and equity is 8%