Question

Bremond Equipment Supply Corporation (BESC) needs to determine its Weighted Average Cost of Capital in order to make a few capital budgeting decisions. The firm has already established the proporation of its capital. Use these proportions in calculating the firm's WAAC.

	Target Market
Source of Capital	Proportions
Long-term debt	30%
Preferred stock	5%
Common stock equity	65%

Debt: The firm can sell a 10-year, $1,000 par value, 7 percent bond for $950. A flotation cost of 3percent of the par value would be required in addition to the discount of $50.
Preferred Stock: The firm has determined it can issue preferred stock at $45 per share par value. The stock will pay an $6.5 annual dividend. The cost of issuing and selling the stock is $2.5 per share.
Common Stock: The firm's common stock is currently selling for $25 per share. The dividend expected to be paid at the end of the coming year is $3.75. Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $1.45. It is expected that to sell, a new common stock issue must be underpriced at $2 per share and the firm must pay $0.75 per share in flotation costs.

Additionally, the firm's marginal tax rate is 20 percent.

To help determine the firm’s WACC, we will break this problem down into steps:

Calculate the rate for the new bond issue, notice is has semi-annual compounding.

Calculate the after-tax cost of the bond issue.

Calculate the cost of the new issue of preferred stock.

Calculate the growth rate of the common stock dividends.

Calculate the cost of the new common stock issue.

Finally, calculate the firm's weighted average cost of capital assuming the firm has exhausted all retained earnings.

Answer 1

Calculation of cost of debt:

FV = 1000

PV = $950 - ($1000 * 3%) = $920

Nper = 10 * 2 = 20

PMT = 1000 * 7% / 2 = 35

Cost of debt can be calculated by using the following excel formula:
=RATE(nper,pmt,pv,fv)*2
=RATE(20,35,-920,1000)*2
= 8.19%

After tax cost of debt = Before tax cost of debt * (1 - tax rate)
= 8.19% * (1 - 0.20)
= 6.55%

Cost of preferred stock = Annual dividend / (Current price - cost)
= $6.5 / ($45 - $2.5)
= $6.5 / $42.5
= 15.29%

Growth rate can be calculated by using the following excel formula:
=RATE(nper,pmt,pv,fv)
=RATE(6,0,-1.45,3.75)
= 17.16%

Cost of new common stock = D1 / (P0 - flotation cost) + g
= $3.75 / ($25 - $2.75) + 0.1716
= 0.1685 + 0.1716
= 34.01%

WACC = (weight of debt * cost of debt) + (weight of preferred stock * cost of preferred stock) + (weight of equity * cost of equity)

= (30% * 6.55%) + (5% * 15.29%) + (65% * 34.01%)

= 24.84%

Weighted average cost of capital (WACC) = 24.84%