Question

The expected return on the market is 11.44 percent, the risk-free rate is 3.82 percent, and the tax rate is 40 percent.  Fairfax Paint has 1,400,000 common shares outstanding that are priced at 35 dollars per share and have an expected return of 19.32 percent and an expected real return of 17.53 percent. Last year, Fairfax Paint common stock had a return of 20.66 percent. The company also has 400,000 shares of preferred stock outstanding that are priced at 20 dollars per share and have an expected return of 12.64 percent and an expected real return of 10.95 percent. Last year, Fairfax Paint preferred stock had a return of 15.16 percent. Finally, the company has 20,000 bonds outstanding with a coupon rate of 13.68 percent, yield-to-maturity of 6.22 percent, current yield of 12.44 percent, face value of 1000 dollars, and price of 1,100 dollars. What is the weighted average cost of capital for Fairfax Paint? Answer as a rate in decimal format so that 12.34% would be entered as .1234 and 0.98% would be entered as .0098.

Answer 1

Weighted average cost of capital = weight of debt*after-tax cost of debt + weight of Preferred stock*cost of Preferred stock + weight of common stock*cost of common stock

Calculation of weights:

Total market value of firm = market value of debt + market value of Preferred stock + market value of common stock

market value = no. of shares or bonds outstanding*market price per share or bond

Total market value of firm = 20,000*$1,100 + 400,000*$20 + 1,400,000*$35 = $22,000,000‬ + $8,000,000‬ + $49,000,000‬ = $79,000,000‬

weight of debt = market value of debt/Total market value of firm = $22,000,000‬ /$79,000,000‬ = 0.28

weight of Preferred stock = $8,000,000‬ /$79,000,000‬ = 0.10

weight of common stock = $49,000,000‬/$79,000,000‬ = 0.62

cost of debt is yield to maturity of the bonds which is 6.22%.

After-tax cost of debt = yield to maturity*(1-tax rate) = 6.22%*(1-0.40) = 6.22%*0.60 = 3.732‬%

Cost of Preferred stock is expected return of 12.64% which is nominal return i.e. including inflation effect.

Cost of common stock is expected return of 19.32% which is nominal return i.e. including inflation effect.

WACC = 0.28*3.732% + 0.10*12.64% + 0.62*19.32% = 1.04496‬% + 1.264‬% + 11.9784% = 14.29% or 0.1429

the weighted average cost of capital for Fairfax Paint is 14.29% or 0.1429.