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

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

market value of debt = bonds outstanding * market price per bond

market value of preferred stock = shares outstanding * market price per share

market value of common stock = shares outstanding * market price per share

weight of debt = market value of debt / total market value

weight of preferred stock = market value of preferred stock / total market value

weight of common stock = market value of common stock / total market value

after-tax cost of debt = YTM of bond * (1 - tax rate)

YTM is calculated using RATE function in Excel with these inputs :

nper = 15*2 (10 years to maturity with 2 semiannual coupon payments each year)

pmt = 1000 * 13% / 2 (semiannual coupon payment = face value * annual coupon rate / 2. This is a positive figure as it is an inflow to the bondholder)

pv = -900 (current bond price = face value * 90%. This is a negative figure as it is an outflow to the buyer of the bond)

fv = 1000 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)

The RATE calculated is the semiannual YTM. To calculate the annual YTM, we multiply by 2.  

after-tax cost of debt = YTM * (1 - tax rate)

after-tax cost of debt ==> 8.80%

cost of preferred stock = annual dividend / current price = $6/$80 = 7.5%

cost of equity (CAPM) = risk free rate + (beta * market risk premium)

cost of equity (CAPM) = 5% + (1.8 * 9%) ==> 21.20%

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

WACC = 13.16%