Question

You have gathered the following information for Frosty Ale, Inc., which has a 40 percent marginal tax rate.

• 2 million common shares outstanding
• 120,000 bonds outstanding
• Current yield to maturity is 7%
• Estimated market risk premium is 6%
• Current common stock price is $25 per share
• Current preferred stock price is $30 per share

• 90,000 preferred shares outstanding
• Estimated beta of stock is 1.2
• 10 year U.S. Treasury yield is 4.8%
• Annual preferred dividend is $3
• Bonds are trading at par
• Bonds have $1,000 face value

What is the firm’s weighted average cost of capital (WACC)? Be sure to very clearly label/identify each input or item and what you are doing to have the opportunity to receive partial credit.

Please show all work. Thank you

Answer 1

rf = risk free rate = 4.8%

(rm-rf) = market risk premium = 6%

beta = 1.2

rd = Cost of debt = 7%

rp = Cost of preference stock = Dividend / share price = $3 / $30 = 10%

re = Cost of Equity = rf + beta * (rm-rf)

= 4.8% + (1.2 * 6%)

= 4.8% + 7.2%

= 12%

Market value of bond = Md = 120,000 * $1,000 = $120,000,000

Market value of Preference stock =Mp = 90,000 * $30 = $2,700,000

Market value of Common Stock = Me = 2,000,000 * $25 = $50,000,000

Total Market Value = MV = Md + Mp + Me = $120,000,000 + $2,700,000 + $50,000,000 = $172,700,000

Weight of Debt =Wd= Md / (MV) = $120,000,000 / $172,700,000 = 0.6948465555 = 0.69485

Weight of Preference stock = Wp = Mp / MV = $2,700,000 / $172,700,000 = 0.0156340475= 0.01563

Weight of Common stock = We = Me / MV = $50,000,000 / $172,700,000 = 0.289519398 = 0.28952

t = tax rate = 40%

WACC = [Wd * rd * (1-t)] + [Wp * rp] + [We *re]

= [0.69485 * 7% * (1-40%)] + [0.01563 * 10%] + [0.28952 * 12%]

= 2.91837% + 0.1563% + 3.47424%

= 6.54891%

Therefore, firm's Weighted Average Cost of Capital is 6.55%