Question

A company has a targeted capital structure of 50% debt and 50% equity. Bond (debt) with face value (or principal amount) of $1200.00 paid 12% coupon annually, mature in 20 years and sell for $950.90. The company’s stock beta is 1.4, the risk free rate is 9% and market risk premium is 6%. The company has a constant growth rate of 6% and a just paid dividend of $3 and sells at $32 per share. If the company’s marginal, tax rate is 35% calculate:

I. The company after tax cost of debt.

II. What is the company cost of equity using capital asset model (CAPM)?                                                           

III. What is the company’s cost of equity using the discount dividend model (DDM)?                                                    

IV. What is the WACC using DDM?

V. If the flotation cost of new equity is 10%. What will be the company’s cost new equity capital?

VI. What would be the company’s WACC using the new capital?      

Answer 1

Answer to Part I:

Face Value = $1,200
Current Price = $950.90

Annual Coupon Rate = 12%
Annual Coupon = 12%*$1,200 = $144

Time to Maturity = 20 years

Let Annual YTM be i%

$950.90 = $144 * PVIFA(i%, 20) + $1,200 * PVIF(i%, 20)

Using financial calculator:
N = 20
PV = -950.90
PMT = 144
FV = 1200

I = 15.39%

Annual YTM = 15.39%

Before-tax Cost of Debt = 15.39%
After-tax Cost of Debt = 15.39% * (1 - 0.35)
After-tax Cost of Debt = 10.00%

Answer to Part II:

Cost of Equity as per CAPM = Risk Free Rate + Beta * Market Risk Premium
Cost of Equity = 9.00% + 1.40 * 6.00%
Cost of Equity = 9.00% + 8.40%
Cost of Equity = 17.40%

Answer to Part III:

Cost of Equity as per DDM = Expected Dividend / Current Price + Growth Rate
Expected Dividend = $3.00 + ($3.00 * 6%) = $3.18

Cost of Equity = $3.18 / $32.00 + 0.06
Cost of Equity = 0.0994 + 0.06
Cost of Equity = 0.1594 or 15.94%

Answer to Part IV:

WACC = (Weight of Debt * After Tax Cost of Debt) + (Weight of Equity * Cost of Equity)
WACC = (0.50 * 0.1000) + (0.50 * 0.1594)
WACC = 0.1297 or 12.97%