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Prudential Transportation has 600,000 shares of common stock outstanding at a market price of $25 a...

Prudential Transportation has 600,000 shares of common stock outstanding at a market price of $25 a share. Last month, Prudential Transportation paid an annual dividend in the amount of $1.00 per share. The dividend growth rate is 5%. Prudential Transportation also has 21,000 bonds outstanding with a face value of $1,000 per bond. The bonds carry a 5% coupon, pay interest annually, and mature in 10 years. The bonds are selling at 104% of face value. The company's tax rate is 25%. What is Prudential Transportation's weighted average cost of capital?

Solutions

Expert Solution

Market Value of Capital

Market Value of Debt = $2,18,40,000 [21,000 x ($1,000 x 104%)]

Market Value of Common Stock = $1,50,00,000 [600,000 x $25]

Total Market Value = $3,68,40,000

Weight of Capital to total market value

Weight of Debt = 0.5928

Weight of Common Stock = 0.4072

Cost of Capital Components

Cost of Debt

Cost of Debt = Yield to Maturity (YTM)

Yield to Maturity [YTM] = Coupon Amount + [(Face Value – Bond Price) / Maturity Years] / [(Face Value + Bond Price)/2]

= [$50 + [($1,000 $1,040) / 10 Years)] / [($1000 + $1,040)/ 2]] x 100

= [($50 - $4) / $1,020] x 100

= 4.49%

After Tax Cost of Debt = Bond’s YTM x [ 1 – Tax Rate]

= 4.49% x (1 – 0.25)

= 3.37%

Cost of Common Stock

Cost of Common Stock = [D1 / P0] + g

= [($1.00 x 1.05) / $25] + 0.05

= 0.0420 + 0.05

= 0.0920

= 9.20%

Weighted Average Cost of Capital (WACC)

Weighted Average Cost of Capital (WACC) = [After-tax Cost of Debt x Weight of Debt] + [Cost of Common Stock x Weight of Common Stock]

= [3.37% x 0.5928] + [9.20% x 0.4072]

= 2% + 3.74%

= 5.74%

“Therefore, the Prudential Transportation's weighted average cost of capital = 5.74%”


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