Question

You are assigned to estimate the firm’s Weighted-Average-Cost-of-Capital (WACC) in order to evaluate capital budgeting opportunities. The company operates in the 20% marginal tax bracket. There are three classes of long-term liabilities and equity outstanding. (1) First, the firm has 127,500 shares of common stock outstanding, which are currently trading at $88.91 per share. You will use the Gordon Growth Model to estimate a required return for the equity holders. The most recent earnings per share was $6.72.You estimate that EPS will grow at an annual rate of 3.2% into the future. (2) There is an issue of 45,000 shares of preferred stock that have a $100 par value and pay 4.70% (perpetual) annual dividends. These shares are currently trading for $63.51. (3) There is an issue of 4,500 coupon bonds outstanding that have a face value of $1,000, mature in 18 years, and pay 5.75% (annual) coupons. These bonds are currently trading at 122.154% of par.

1.What the Weight-Average-Cost-of-Capital (WACC)?

**show steps please********

Answer 1

Debt:

Number of bonds outstanding = 4,500
Face Value = $1,000

Current Price = 122.154% * $1,000
Current Price = $1,221.54

Value of Debt = 4,500 * $1,221.54
Value of Debt = $5,496,930

Annual Coupon Rate = 5.75%
Annual Coupon = 5.75% * $1,000
Annual Coupon = $57.50

Time to Maturity = 18 years

Let Annual YTM be i%

$1,221.54 = $57.50 * PVIFA(i%, 18) + $1,000 * PVIF(i%, 18)

Using financial calculator:
N = 18
PV = -1221.54
PMT = 57.50
FV = 1000

I = 4.00%

Annual YTM = 4.00%

Before-tax Cost of Debt = 4.00%
After-tax Cost of Debt = 4.00% * (1 - 0.20)
After-tax Cost of Debt = 3.20%

Preferred Stock:

Number of shares outstanding = 45,000
Current Price = $63.51

Annual Dividend = 4.70% * $100
Annual Dividend = $4.70

Value of Preferred Stock = 45,000 * $63.51
Value of Preferred Stock = $2,857,950

Cost of Preferred Stock = Annual Dividend / Current Price
Cost of Preferred Stock = $4.70 / $63.51
Cost of Preferred Stock = 7.40%

Common Stock:

Number of shares outstanding = 127,500
Current Price = $88.91

Value of Common Stock = 127,500 * $88.91
Value of Common Stock = $11,336,025

Expected EPS = Current EPS * (1 + Growth Rate)
Expected EPS = $6.72 * 1.032
Expected EPS = $6.93504

Cost of Common Stock = Expected EPS / Current Price + Growth Rate
Cost of Common Stock = $6.93504 / $88.91 + 0.032
Cost of Common Stock = 11.00%

Value of Firm = Value of Debt + Value of Preferred Stock + Value of Common Stock
Value of Firm = $5,496,930 + $2,857,950 + $11,336,025
Value of Firm = $19,690,905

Weight of Debt = $5,496,930 / $19,690,905
Weight of Debt = 0.2792

Weight of Preferred Stock = $2,857,950 / $19,690,905
Weight of Preferred Stock = 0.1451

Weight of Common Stock = $11,336,025 / $19,690,905
Weight of Common Stock = 0.5757

WACC = Weight of Debt * After-tax Cost of Debt + Weight of Preferred Stock * Cost of Preferred Stock + Weight of Common Stock * Cost of Common Stock
WACC = 0.2792 * 3.20% + 0.1451 * 7.40% + 0.5757 * 11.00%
WACC = 8.30%