Question

London Inc. recently hired you as a consultant to estimate the company’s WACC. You have obtained the following information.

• The firm has $400,000 of debt outstanding, $200,000 of preferred stock, $300,000 of retained earnings and $300,000 of new common stock.
• The firm’s bonds mature in 20 years and have a 10% yield to maturity.
• The company’s tax rate is 40%.
• The firm’s preferred stock currently sells for $80 a share and pays an annual dividend of $11.
• The firm is expected to pay a $2.50 dividend at year end (D1 = $2.50), the dividend is expected to grow at a constant rate of 5.50% a year, and the common stock currently sells for $52.50 a share. The issuance of new common stock would incur the firm 6% flotation cost.
• The firm has two proposed projects with the same level of risk as of the firm. Project A’s IRR is 12% while project B’s IRR is 9%.

1. The weight of debt is: *

A. $400,000

B. 33.33%

C. 16.67%

D. 25%

E. None of the above

2. The weight of preferred stock is: *

A. $200,000

B. 33.33%

C. 16.67%

D. 25%

E. None of the above

3. The weight of common stock from retained earnings is: *

A. $300,000

B. 33.33%

C. 16.67%

D. 25%

E. None of the above

4. The weight of external equity is: *

A. $600,000

B. 33.33%

C. 16.67%

D. 25%

E. None of the above

5. The after-tax cost of debt is: *

A. 10%

B. 4%

C. 6%

D. 14%

E. None of the above

6. The cost of preferred stock is: *

A. 14.0%

B. 6%

C. 13.5%

D. 13.75%

E. None of the above

7. The cost of common equity using retained earnings is: *

A. 13.75%

B. 10%

C. 10.26%

D. 10.57%

E. None of the above

8. The cost of external equity is: *

A. 13.75%

B. 10.26%

C. 6%

D. 10.57%

E. None of the above

9. The weighted average cost of capital (WACC) is: *

A. 19.50%

B. 10.29%

C. 9.50%

D. 15%

E. None of the above

10. Which of the two proposed project(s) would be accepted? *

A. Project A

B. Project B

C. Project A and project B

D. None

E. Use NPV to choose projects

Answer 1

Answer 1 to 4:

Value of Debt = $400,000
Value of Preferred Stock = $200,000
Value of Retained Earnings = $300,000
Value of New Common Stock = $300,000

Value of Firm = Value of Debt + Value of Preferred Stock + Value of Retained Earnings + Value of New Common Stock
Value of Firm = $400,000 + $200,000 + $300,000 + $300,000
Value of Firm = $1,200,000

Weight of Debt = Value of Debt / Value of Firm
Weight of Debt = $400,000 / $1,200,000
Weight of Debt = 33.33%

Weight of Preferred Stock = Value of Preferred Stock / Value of Firm
Weight of Preferred Stock = $200,000 / $1,200,000
Weight of Preferred Stock = 16.67%

Weight of Retained Earnings = Value of Retained Earnings / Value of Firm
Weight of Retained Earnings = $300,000 / $1,200,000
Weight of Retained Earnings = 25.00%

Weight of New Common Stock = Value of New Common Stock / Value of Firm
Weight of New Common Stock = $300,000 / $1,200,000
Weight of New Common Stock = 25.00%

Answer 5.

Cost of Debt = Annual YTM
Cost of Debt = 10.00%

After-tax Cost of Debt = Cost of Debt * (1 - Tax Rate)
After-tax Cost of Debt = 10.00% * (1 - 0.40)
After-tax Cost of Debt = 6.00%

Answer 6.

Cost of Preferred Stock = Annual Dividend / Current Price
Cost of Preferred Stock = $11.00 / $80.00
Cost of Preferred Stock = 13.75%

Answer 7.

Cost of Internal Equity = Expected Dividend / Current Price + Growth Rate
Cost of Internal Equity = $2.50 / $52.50 + 0.0550
Cost of Internal Equity = 0.1026 or 10.26%

Answer 8.

Cost of External Equity = Expected Dividend / [Current Price * (1 - Flotation Cost)] + Growth Rate
Cost of External Equity = $2.50 / [$52.50 * (1 - 0.06)] + 0.0550
Cost of External Equity = $2.50 / $49.35 + 0.0550
Cost of External Equity = 0.1057 or 10.57%

Answer 9.

WACC = Weight of Debt * After-tax Cost of Debt + Weight of Preferred Stock * Cost of Preferred Stock + Weight of Retained Earnings * Cost of Retained Earnings + Weight of New Common Stock * Cost of External Equity
WACC = 33.33% * 6.00% + 16.67% * 13.75% + 25.00% * 10.26% + 25.00% * 10.57%
WACC = 9.50%

Answer 10.

Firm should accept Project A as its IRR is higher than WACC and reject Project B as its IRR is less than WACC.