Question

Geralt Technologies is considering a major expansion program that has been proposed by the company’s information technology group. Before proceeding with the expansion, the company need to develop an estimate of its cost of capital. Assume that you are an assistant to Henry Cavill, the financial vice-president. Your first task is to estimate Geralt’s cost of capital. Henry has provided you with the following data, which he believes may be relevant to your task:

(i) The firm’s tax rate is 40%.

(ii) The current market price of Geralt’s $1,000 par value, 12 percent coupon, semi-annual payment, non-callable bonds with 15 years remaining to maturity is $1,153.72. Geralt does not use short-term interest-bearing debt on a permanent basis.

(iii) The current price of the firm’s 10%, $100 par value, annual dividend, perpetual preferred stock is $111.10. The company would incur a issuing cost of 6%.

(iv) Geralt’s common stock is currently selling at $50 per share. Its last dividend was $4.19, and dividends are expected to grow at a constant rate of 5% in the foreseeable future. Geralt’s beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is estimated to be 6%. For the bond-yield-plus-risk-premium approach, the firm uses a 4% point risk premium.

(v) Geralt’s target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.

To structure the task somewhat, Henry has asked you to answer the following questions ( Without using financial Calculator ):

(a) (1) What sources of capital should be included when you estimate Geralt’s weighted average cost of capital (WACC)?

(2) Should the component costs be figured on a before-tax or an after-tax basis?

(b) What is the market interest rate on Geralt’s debt? What is its component After-tax cost of debt?

(c) What is the firm’s cost of preferred stock?

Answer 1

a. 1. We should source all stock, preferred stock and debt to arrive at the WACC. Because, these capital are raised to investment purposes and comes with some cost based on different classes of capital. Hence, we should use WACC for discounting the future after tax cash flows.

2.Only interest cost has tax shield, hence cost of debt should be taken after tax basis. Interest expenses are tax deductble which lowers the taxable income. For other types of capital i.e. stock and preferred stock, the returns are taken out from the net income (which is after tax item).

3. Cost of debt can be caluclated as (semi annual coupon payment)/current bond price=$60/$1153.72=5.2%

after tax cost debt=cost of debt *(1-tax rate)=5.2%*0.6=3.12%

4. Cost of preferred stock = Annual Dividend/Price of preffered stock=$10/$111.1=9%

Cost of equity=Risk free rate of return +Beta (risk premium)=7%+1.2(4%)=11.8%

Usually, treasury bonds are considered as risk free and we should take that yield

WACC=(weight of equity*cost of equity)+(weight of debt*after tax cost of debt)+(weight of preferred stock*cost of preferred stock)=(0.6*11.8%)+(0.3*3.12%)+(0.1*9%)=8.916%