Question

Sueshe Restaurants plc currently has 50 million shares outstanding trading at £3.00 each, and the firm has just paid a divided of £0.20. Sueshe also has 3 million bonds, which are trading at £105 each with a yield to maturity of 6%. Dividends are expected to grow annually by 5% and Sueshe faces a corporate taxation rate of 20%. What is Sueshe’s weighted average cost of capital (WACC)?

Answer 1

Solution:

Calculation of Cost of Equity:

The price of a share of a firm is calculated using the following formula:

P0 = D0 * [ ( 1 + g ) ] / ( ke – g )

Where

P0 = Price of the share;      D0 = Dividend paid in Year 0 i.e., Recent dividend paid ; g = growth rate ;

ke = Cost of equity

As per the information given in the question we have ;

D0 = £ 0.20 ;       g = 5 % = 0.05 ; P0 = £ 3.00 ;   ke = To find

Applying the above values in the formula we have

3 = [ 0.20 * ( 1 + 0.05 ) ] / (ke – 0.05)         

3 = [ 0.20 * ( 1.05 ) ] / (ke – 0.05)

3 = 0.21 / (ke – 0.05)

3 * (ke – 0.05) = 0.21                                  

ke – 0.05 = 0.21 / 3

ke – 0.05 = 0.07

ke = 0.05 + 0.07 = 0.12

ke = 12.00 %

Thus the cost of equity is = 12.00 %

Calculation of WACC:

As per the information given in the question             

No. of shares outstanding = 50 Million shares ; Market price per share = £ 3 ;

Thus Market value of the Equity shares = No. of shares outstanding * Market price per share

= 50 Million shares * £ 3 = £ 150 Million

No. of bonds outstanding = 3 Million bonds ; Market price of each corporate bond = £ 105 ;

Thus Market value of the bonds = No. of bonds outstanding * Market price per bond

= 3 Million bonds * £ 105 = £ 315 Million

Thus Weight of equity shares = [ 150 / ( 150 + 315 ) ] = 150 / 465 = 0.322581

Thus Weight of bonds = [ 315 / ( 150 + 315 ) ] = 315 / 465 = 0.677419

Cost of equity = 12 %   ; Yield to maturity of bonds = cost of debt = 6 %

The formula for calculating the weighted average cost of capital is =

WACC = [ Ke * We ] + [ ( Kd * ( 1 - t ) ) * Wd ]

Ke = Cost of equity ; We = Weight of equity ; Kd = Cost of debt    ; t = Income tax rate ; Wd = Weight of debt

                                

As per the information available in the question we have

Ke = 12.00 % = 0.12   ; We = 0.322581 ;   Kd = 6 % = 0.06 ; t = 20 % = 0.20   ; Wd = 0.677419 ;

Applying the above values in the formula we have

= [ 0.12 * 0.322581 ] + [ ( 0.06 * ( 1 – 0.20 ) ) * 0.677419 ]

= [ 0.12 * 0.322581 ] + [ ( 0.06 * 0.80 * 0.677419 ]

= [ 0.038710 + 0.032516 ]

= 0.071226

= 7.1226 %   

= 7.12 % ( when rounded off to two decimal places )

Thus the Weighted Average Cost of Capital is = 7.12 %