Question

The Belfast Corp. has 40 million shares of common stock with a current market price of $14.00 per share. They have $270 million in par value of long-term bonds outstanding that currently sell for $935 per $1,000 par value. The bonds have a coupon rate of 7.6% and a maturity of 20 years. Assume annual coupon payments. Horizon also has 1 million shares of preferred stock with a current market price of $108 per share. The dividend on this preferred stock is $8.80 per year. Flotation costs on new preferred stock will be 3%.

The dividend on common stock in the most recent year (i.e. D₀) was $0.60. The firm has a growth rate of 4.5% that is expected to continue indefinitely into the future. On new common stock flotation costs would be about 8%. Flotation costs on new bonds would be negligible.

a. Assuming a combined state and federal marginal tax rate of 40%, estimate Belfast's cost of capital. Calculate the WACC twice. The first time, assume they use retained earnings for additional equity, and the second time, assume that they use new common stock. The only thing that will change the second time you calculate the WACC is the cost of common equity.

b. Discuss, in general terms, how a firm’s investment policy can affect its WACC.

c. Explain how a company’s capital structure policy could affect its WACC.

Answer 1

Common Equity:

Number of Shares Outstanding = 40 million, Current Market Price of Common Stock = P0 = $ 14 per share,

Dividend Per Share =D0 = $ 0.6, Dividend Growth Rate = g = 4.5 %, Flotation Costs = F = 8%

Cost of Equity = r(e) = [{D0 x (1+g)} / P0] + g = [{0.6 x 1.045} / 14 ] + 0.045 = 0.08978 or 8.978 %

Cost of New Equity = r(e)' = [(D1/P0) x {1/(1-F)}] + g = [(0.627/14) x {1/(0.92}] + 0.045 = 0.09368 or 9.368 %

Market Value of Equity = Number of Common Stock Outstanding x Common Stock Price = E = 40 x 14 = $ 560 million

Preferred Stock:

Number of Preferred Stock Outstanding = 1 million, Current Market Price of Preferred Stock = $ 108 per share, Dividend = $ 8.8 per share

Floatation Cost = 3 %

As the preferred stock is already outstanding, the floatation cost is irrelevant.

Cost of Preferred Stock = r(p) = Dividend / Preferred Stock Market Price = 8.8 / 108 = 0.08148 or 8.148 %

Market Value of Preferred Stock = P = 1 x 108 = $ 108 million

Debt:

Par Value of Debt = $ 270 million, Par Value = $ 1000 and Market Value = $ 935, Bond Coupon Rate = 7.6% per annum payable annually, Bond Maturity = 20 years

Let cost of debt be r(d) = R

Annual Coupon = Par Value x Annual Coupon Rate = 1000 x 0.076 = $ 76

935 = 76 x (1/R) x [ 1-{1/(1+R)^(20)}] + 1000 / (1+R)^(20)

R = 0.08276 or 8.276 %

Number of bonds issued = (270000000 / 1000) = 270000

Market Value of Bond = D = 270000 x 935 = $ 252.45 million

Tax Rate = t = 40%

V = D + E + P = 252.45 + 560 + 108 = $ 920.45 million

(a) WACC when common equity is entirely financed by retained earnings:

WACC = (1-t) x r(d) x (D/V) + r(p) x P + r(e) x E = (1-0.4) x 8.276 x (252.45 / 920.45) + 8.148 x (108 / 920.5) + 8.978 x (560 / 920.5) = 7.7801 %

WACC when common equity is entirely financed by new equity issue:

WACC = (1-t) x r(d) x (D/V) + r(p) x P + r(e) x E = (1-0.4) x 8.276 x (252.45 / 920.45) + 8.148 x (108 / 920.5) + 9.368 x (560 / 920.5) = 8.0174 %

(b) A firm's investment policy usually maintains similarity(uniformity) in the degree of risk of all its investments. If the firm suddenly props up or resets down the general level of risk of its investments (relative to the firm's overall risk levels), the firm's cost of debt and cost of equity both changes. This in turn alters the firm's WACC.

(c) A firm's capital structure impacts the firm's WACC in a substantial fashion. An all equity financed firm usually has a higher cost of capital as compared to a leveraged firm, as debt reduces the firm's overall cost of capital owing to the positive impact of interest tax shield. However, using too much debt increases default risk which in turn inflates the firm's cost of equity, thereby impacting its WACC. Further, using retained earnings instead of costlier new common equity issue also impacts the firm's WACC.