Question

Company has the following target capital structure, in market value terms:

Debt          30%

Preferred Stock   10%

Common Stock 60%

In addition, you know the following:

· At present the company’s debt is composed of $1,000 par bonds issued exactly three years ago, that pay a semiannual coupon, with a nominal annual rate of 7%, that have a ten-year maturity, and that are now selling for $1,150.

· The company’s preferred stock is paying a $1.50 annual dividend and is currently selling for $97.50 per share.

· The company’s tax rate is 40%.

· The company’s common stock has a beta of .80.

· The risk-free rate of interest is 3.0%

· The market risk premium (MRP) is 5%.

Calculate the weighted average cost of capital for the Floating Cloud Company

Answer 1

Debt:

Par Value = $1,000
Current Price = $1,150

Annual Coupon Rate = 7.00%
Semiannual Coupon Rate = 3.50%
Semiannual Coupon = 3.50% * $1,000
Semiannual Coupon = $35

Time to Maturity = 7 years
Semiannual Period to Maturity = 14

Let Semiannual YTM be i%

$1,150 = $35 * PVIFA(i%, 14) + $1,000 * PVIF(i%, 14)

Using financial calculator:
N = 14
PV = -1150
PMT = 35
FV = 1000

I = 2.240%

Semiannual YTM = 2.240%
Annual YTM = 2 * 2.240%
Annual YTM = 4.480%

Before-tax Cost of Debt = 4.480%
After-tax Cost of Debt = 4.480% * (1 - 0.40)
After-tax Cost of Debt = 2.688%

Preferred Stock:

Current Price = $97.50
Annual Dividend = $1.50

Cost of Preferred Stock = Annual Dividend / Current Price
Cost of Preferred Stock = $1.50 / $97.50
Cost of Preferred Stock = 1.538%

Common Stock:

Cost of Common Stock = Risk-free Rate + Beta * Market Risk Premium
Cost of Common Stock = 3.00% + 0.80 * 5.00%
Cost of Common Stock = 7.000%

WACC = Weight of Debt * After-tax Cost of Debt + Weight of Preferred Stock * Cost of Preferred Stock + Weight of Common Stock * Cost of Common Stock
WACC = 0.30 * 2.688% + 0.10 * 1.538% + 0.60 * 7.000%
WACC = 5.16%