Question

Steady Company’s current share price is $18 and it is expected to pay a $1.10 dividend per share next year. After that, the firm’s dividends are expected to grow at a rate of 3% per year.
a) What is an estimate of Steady Company’s cost of equity? (1 mark)
b) Steady Company also has preference shares outstanding that pay a $2.20 fixed dividend. If this share is currently priced at $30, what is Steady Company’s cost of preference shares? (1 mark)
c) Steady Company has existing debt issued three years ago with a coupon rate of 7%. The firm just issued new debt at par with a yield of 7.5%. What is Steady Company’s pre-tax cost of debt? (1 mark)
d) Steady Company has five million ordinary shares outstanding and one million preference shares outstanding, and its equity has a total book value of $50 million. Its debts have a market value of $20 million. If Steady Company’s ordinary and preference shares are priced as in parts a) and b), what is the market value of Steady Company’s assets? (1 mark)
e) Steady Company faces a 30% tax rate. Given the information and your answers in a) to d) above, calculate Steady Company’s WACC?

Answer 1

Answer a.

Cost of Equity = Expected Dividend / Current Price + Growth Rate
Cost of Equity = $1.10 / $18.00 + 0.03
Cost of Equity = 0.0611 + 0.0300
Cost of Equity = 0.0911 or 9.11%

Answer b.

Cost of Preferred Stock = Annual Dividend / Current Price
Cost of Preferred Stock = $2.20 / $30.00
Cost of Preferred Stock = 0.0733 or 7.33%

Answer c.

Pretax Cost of Debt = Yield to Maturity
Pretax Cost of Debt = 7.50%

Answer d.

Market Value of Debt = $20,000,000

Market Value of Preferred Stock = Number of Preferred Stock * Current Price per share
Market Value of Preferred Stock = 1,000,000 * $30.00
Market Value of Preferred Stock = $30,000,000

Market Value of Equity = Number of Ordinary Stock * Current Price per share
Market Value of Equity = 5,000,000 * $18.00
Market Value of Equity = $90,000,000

Market Value of Assets = Market Value of Debt + Market Value of Preferred Stock + Market Value of Equity
Market Value of Assets = $20,000,000 + $30,000,000 + $90,000,000
Market Value of Assets = $140,000,000

Answer e.

Weight of Debt = Market Value of Debt / Market Value of Assets
Weight of Debt = $20,000,000 / $140,000,000
Weight of Debt = 0.14286

Weight of Preferred Stock = Market Value of Preferred Stock / Market Value of Assets
Weight of Preferred Stock = $30,000,000 / $140,000,000
Weight of Preferred Stock = 0.21429

Weight of Equity = Market Value of Equity / Market Value of Assets
Weight of Equity = $90,000,000 / $140,000,000
Weight of Equity = 0.64285

WACC = Weight of Debt * Pretax Cost of Debt * (1 - Tax Rate) + Weight of Preferred Stock * Cost of Preferred Stock + Weight of Equity * Cost of Equity
WACC = 0.14286 * 7.50% * (1 - 0.30) + 0.21429 * 7.335 + 0.64285 * 9.11%
WACC = 0.14286 * 5.25% + 0.21429 * 7.335 + 0.64285 * 9.11%
WACC = 8.18%