Question

A company has an optimal capital structure of 35% debt financing, 15% preferred stock financing, 50%

    common equity financing. The tax rate is 25%, the preferred stock dividend is $2 per share, next period’s common stock dividend is $1 per share and is expected to grow by 5% in future years, the price of the company’s common stock is $10, the price of the company’s preferred stock is $25, the bond coupon rate is 4%. Assume that retained earnings is the only source of common equity financing.

a. Calculate the weighted average cost of capital.

b. Suppose the operating profitability ratio is 5% and the capital requirement ratio is 55%. Calculate the return on invested capital.

c. Is the Economic Value Added positive, negative, or zero for this company?

d. Referring to your answers to parts a, b, and c, do you anticipate that the stock price of this company will increase or decrease?

Answer 1

Answer (a):

Cost of common equity = Dividend next period / Price + Growth % = (1 / 10) + 5% = 15%

Cost of preferred stock = Annual dividend / Price = 2/ 25 = 8%

Cost of debt = 4%

WACC = Cost of common equity * weight of common equity + cost of preferred stock * weight of preferred stock + Cost of debt * (1 - Tax rate) * weight of debt

= 15% * 50% + 8% * 15% + 4% * (1 - 25%) * 35%

= 9.75%

Weighted average cost of capital = 9.75%

Answer (b):

Given:

Operating profitability ratio is = 5% and

Capital requirement ratio is = 55%

Return on invested capital = 5% / 55% = 9.09%

Return on invested capital = 9.09%

Answer (c):

Economic Value Added is negative for this company.

We observe from answer a and answer b above:

Weighted average cost of capital = 9.75%

Return on invested capital = 9.09%

Since ROCE < WACC, economic value added is negative.

Answer (d):

Based on answers to parts a, b, and c, we anticipate that the stock price of this company will decrease.

As the ROCE < WACC, stock price is expected to decrease.