Question

2. Prashant Ceramics Limited, is interested in estimating its weighted average cost of capital (WACC) now that it is in its rapid growth stage. Prashant Ceramics has 100,000 $1,000 par, 13 percent semi-annual coupon bonds outstanding. It also has 1 Million shares of 6% preferred stock outstanding with $100 face value. The preferred stock sells for $80 per share. The common stock sells for $70 per share and has a beta of 1.8. It has 1.5 million shares of common stock outstanding. The bonds have 15 years to maturity and sell for 90 percent of par. The market risk premium is 9.0 percent, T-bills are yielding 5.0 percent, and the firm’s tax rate is 40 percent.

1. Determine the after-tax cost of the long-term bond issue.   
2. Determine the after-tax cost of preferred stock.
3. Determine the after-tax cost of common stock.
4. Compute the WACC for Prashant Ceramics Limited.   

Answer 1

a) After-tax Cost of the Long-term Bond Issue

Cost of debt = [ C+ ( {FV - P} / t) ] / [ (FV + P ) / 2 ]

where,
C = Coupon = $1000 * 13%*1/2 = $65
FV = Face Value = $1,000
P = Price of Bond = 90% of Par = $900
t = Time to maturity = 15yrs * 2 = 30


Cost of debt = [ 65 + ( { 1000 - 900 } / 30 ) ] / [ (1000+900) / 2 }
= [ 65 + (100 / 30) ] / [ 1900 / 2 ]
= [ 65 + 3.333 ] / 950
= 68.333 / 950
= 0.07193
  
Annual Cost of Debt = 0.07193 * 2 = ~14.39%
After-tax cost of Debt = 14.39 - 40% = ~8.63%

b) After-tax cost of preferred stock

Cost of Preferred stock = Pref dividend / Pref. price per share * 100
= 6 / 80 * 100
= 7.5%

After-tax cost of preferred stock = 7.5%

c) After-tax cost of common equity

Cost of equity = Risk Free Rate + Beta * Risk Premium
= 5 % + 1.8 * 9%
= 21.2%

After-tax cost of common equity = 21.2%

d) WACC for Prashant Ceramics Limited

i) Compuation of Weights

Total Market Value of Common stock = No. of shares * Market Price
= 1.5 million * $70
= $105 million

Total Market Value of Preference stock =  No. of shares * Market Price
= 1 million * $80
= $80 million

Total Market Value of Bonds = No. of bonds * Price of Bond
= 100,000 * $900
= $90 million

Total Value of the Firm = $105 mm + $80 mm + $90 mm = $275mm

Equity Weight = 105/275 = 0.38
Preference Weight = 80/275 = 0.29
Debt Weight = 90/275 = 0.33

ii) Calculation of WACC

WACC = Cost of Equity * Weight of Eq + Cost of Pref. * Pref. Weight + After tax Cost of debt * Debt Weight
= 8.63% * 0.38 + 7.5% * 0.29 + 21.2% * 0.33
= 3.279 % + 2.175% + 6.996%
= 12.45%

Ans : WACC = 12.45%