Question

3. Long term capital structure of company KL is given below:

Sources of capital Book value ($ 000)

Debts 20,000

Preferred stock 5,000

Common stock 7,500

Reserves (re) 17,500

Total capital 50,000

The interest rate for debt is overall 10%, dividend for common stock is $1.3 and $1.5 for preferred stock per share, respectively. Preferred -and stock price is $10 per share, growth rate is 0.06. Suppose that the average income tax ratio is 25 % and the corporate tax ratio is 20 %, calculate and interpret the WACC of the Company.

Answer 1

1) Cost Of Common Equity Share:

Using the Dividend Discount Model Ke(Cost of Equity) can be identified:-

Current Stock Price = (Dividend paid on year 1)/(Ke - g) {Where, g is growth rate, Ke is Cost of Equity}

First, we have to find the Dividend paid on year 1= $1.3 * (1+g) = 1.3*(1.06) = $1.378 {Assuming Given dividend figures in question are of present Financial Year}

Therefore,

CSP = 1.378/(Ke - 0.06)

$10 = 1.378/(Ke - 0.06)

Ke = 0.1978 or 19.78% .....(1)

2) Cost Of Preferred Equity Share:

Using the Dividend Discount Model Ke(Cost of Equity) can be identified:-

Current Stock Price = (Dividend paid on year 1)/(Ke - g) {Where, g is growth rate, Ke is Cost of Equity}

First, we have to find the Dividend paid on year 1= $1.5 * (1+g) = 1.5*(1.06) = $1.59 {Assuming Given dividend figures in question are of present Financial Year}

Therefore,

CSP = 1.59/(Ke - 0.06)

$10 = 1.59/(Ke - 0.06)

Ke = 0.219 or 21.90% .....(2)

3) Cost of Debt:

Given Interest rate on the debt is the Cost of Debt = 10%

After Tax Cost of Debt = 10%*(1-Corporate Tax Rate) = 0.10*(1-0.20) = 0.08

4) WACC:

WACC = (Weight of Debt*Cost of After-Tax Debt) + (Weight of Common Equity*Cost of Common Equity) + (Weight of Preferred Equity*Cost of Preferred Equity)

{f you are using market values for equity and debt for calculating the gearing and for calculating the WACC (as usually we always do), then reserves are not relevant (The most obvious reason for the market value of equity is more than the nominal value is because of the reserves – they are effectively already included)

Therefore Assuming the given $10 price of Preferred and common equity share is the Current Market Price, so we would not include reserve in our calculation.

If we have to include that in calculation then weights of common equity and preferred equity would change as reserve would also be included in it (then the value of equity is the share capital + reserves)}

a) Weight of Debt = 20,000/(20,000 + 5,000 + 7,500) = 0.615384

b) Weight of Common Equity = 7,500/(20,000 + 5,000 + 7,500) = 0.230769

c) Weight of Preferred Equity = 5,000/(20,000 + 5,000 + 7,500) = 0.153846

WACC = (0.615384*0.08) + (0.230769*0.1978) + (0.153846*0.219)   

= .128569 or 12.86%(approx)