Question

Longstreet Communications Inc. (LCI) has the following capital structure, which it WACC

considers to be optimal: debt = 25% (LCI has only long-term debt), preferred stock = 15%, and

common stock = 60%. LCI’s tax rate is 40%, and investors expect earnings and dividends to

grow at a constant rate of 6% in the future. LCI paid a dividend of $3.70 per share last year

(D0), and its stock currently sells at a price of $60 per share. Ten-year Treasury bonds yield 6%,

the market risk premium is 5%, and LCI’s beta is 1.3. The following terms would apply to new

security offerings. Preferred: New preferred stock could be sold to the public at a price of $100

per share, with a dividend of $9. Flotation costs of $5 per share would be incurred. Debt: Debt

could be sold at an interest rate of 9%. Common: New common equity will be raised only by

retaining earnings.

a. Find the component costs of debt, preferred stock, and common stock. For

common stock show using both DCF (DDM) and CAPM.

b. What is the WACC?

Answer 1

Cost of Equity using CAPM = Risk free rate + (Beta * Market Risk Premium)

= 6% + (1.3 * 5%)

= 6% + 6.5%

= 12.5%

Cost of Equity using DDM

Cost of Common Equity = [Expected Dividend / (Market Price )] + growth rate

= [(3.70 * 1.06) / 60 ] + 0.06

= 12.54%

After-Tax Cost of Debt of the firm = Interest Cost * (1 - tax rate)

= 9% * (1 - 0.40)

=5.4%

Calculation of Cost of Preferred Stock

Cost of Preferred Stock = Annual Dividend / (Current Market Price - Flotation Cost)

= 9 / (100 - 5)

= 0.0947368421 or 9.47%

Calculation of WACC of the Firm

WACC = (Cost of After tax Debt * Weight of Debt) + ( Cost of Equity * Weight of Equity) + (Cost of Preferred Stock * Weight of Preferred Stock)

= (5.4% * 0.25) + (12.52% * 0.60) + (9.47% * 0.15)

= 1.35% + 7.51% + 1.42%

= 10.28%

Note : It is better to take average of Cost of Equity under CAPM and DDM