In: Finance
Match the Weighted Average Cost of Capital to each of the scenarios given for ABC Corporation.
1. Target capital structure: 34% debt, 7% preferred stock and 59% common equity. Yield to maturity on bonds: 8.9%; Preferred stock dividend: $6.21 per year; current market price of preferred stock is $68.71. CAPM data for common equity: risk-free rate is 4.6%; market risk premium for the average stock is 4.2%; ABC has a beta of 1.69. ABC's marginal tax rate is 40%.
2. Target capital structure: 40% debt, 10% preferred stock and 50% common equity. Yield to maturity on bonds: 5.9%; Preferred stock dividend: $6.87 per year; current market price of preferred stock is $69.37. CAPM data for common equity: risk-free rate is 4.9%; market risk premium for the average stock is 4.1%; ABC has a beta of 1.96. ABC's marginal tax rate is 40%.
3. Target capital structure: 35% debt, 13% preferred stock and 52% common equity. Yield to maturity on bonds: 5.0%; Preferred stock dividend: $6.35 per year; current market price of preferred stock is $68.85. CAPM data for common equity: risk-free rate is 5.0%; market risk premium for the average stock is 3.0%; ABC has a beta of 2.35. ABC's marginal tax rate is 40%.
4. Target capital structure: 46% debt, 11% preferred stock and 43% common equity. Yield to maturity on bonds: 7.9%; Preferred stock dividend: $7.79 per year; current market price of preferred stock is $70.29. CAPM data for common equity: risk-free rate is 4.1%; market risk premium for the average stock is 5.5%; ABC has a beta of 1.87. ABC's marginal tax rate is 40%.
5. Target capital structure: 47% debt, 15% preferred stock and 38% common equity. Yield to maturity on bonds: 9.0%; Preferred stock dividend: $7.02 per year; current market price of preferred stock is $69.52. CAPM data for common equity: risk-free rate is 4.3%; market risk premium for the average stock is 11.0%; ABC has a beta of 0.80. ABC's marginal tax rate is 40%.
A.
8.51%
B.
9.03%
C.
9.35%
D.
8.87%
E.
9.59%
Answer to Part 1.
Weight of Debt = 0.34
Weight of Preferred Stock = 0.07
Weight of Common Stock = 0.59
After Tax Cost of Debt = 8.9% * (1 – 0.40)
After Tax Cost of Debt = 5.34%
Cost of Preferred Stock = Annual Dividend / Current Price *
100
Cost of Preferred Stock = $6.21 / $68.71 * 100
Cost of Preferred Stock = 9.04%
Cost of Equity = Risk Free Rate + Beta * Market Risk
Premium
Cost of Equity = 4.60% + 1.69 * 4.20%
Cost of Equity = 11.70%
WACC = (Weight of Debt * After Tax Cost of Debt) + (Weight of
Preferred Stock * Cost of Preferred Stock) + (Weight of Equity *
Cost of Equity)
WACC = (0.34 * 5.34%) + (0.07 * 9.04%) + (0.59 * 11.70%)
WACC = 9.35%
Answer to Part 2.
Weight of Debt = 0.40
Weight of Preferred Stock = 0.10
Weight of Common Stock = 0.50
After Tax Cost of Debt = 5.9% * (1 – 0.40)
After Tax Cost of Debt = 3.54%
Cost of Preferred Stock = Annual Dividend / Current Price *
100
Cost of Preferred Stock = $6.87 / $69.37 * 100
Cost of Preferred Stock = 9.90%
Cost of Equity = Risk Free Rate + Beta * Market Risk
Premium
Cost of Equity = 4.90% + 1.96 * 4.10%
Cost of Equity = 12.94%
WACC = (Weight of Debt * After Tax Cost of Debt) + (Weight of
Preferred Stock * Cost of Preferred Stock) + (Weight of Equity *
Cost of Equity)
WACC = (0.40 * 3.54%) + (0.10* 9.90%) + (0.50 * 12.94%)
WACC = 8.87%
Answer to Part 3.
Weight of Debt = 0.35
Weight of Preferred Stock = 0.13
Weight of Common Stock = 0.52
After Tax Cost of Debt = 5.0% * (1 – 0.40)
After Tax Cost of Debt = 3.00%
Cost of Preferred Stock = Annual Dividend / Current Price *
100
Cost of Preferred Stock = $6.35 / $68.85 * 100
Cost of Preferred Stock = 9.22%
Cost of Equity = Risk Free Rate + Beta * Market Risk
Premium
Cost of Equity = 5.00% + 2.35 * 3.00%
Cost of Equity = 12.05%
WACC = (Weight of Debt * After Tax Cost of Debt) + (Weight of
Preferred Stock * Cost of Preferred Stock) + (Weight of Equity *
Cost of Equity)
WACC = (0.35 * 3.00%) + (0.13 * 9.22%) + (0.52 * 12.05%)
WACC = 8.51%
Answer to Part 4.
Weight of Debt = 0.46
Weight of Preferred Stock = 0.11
Weight of Common Stock = 0.43
After Tax Cost of Debt = 7.9% * (1 – 0.40)
After Tax Cost of Debt = 4.74%
Cost of Preferred Stock = Annual Dividend / Current Price *
100
Cost of Preferred Stock = $7.79/ $70.29 * 100
Cost of Preferred Stock = 11.08%
Cost of Equity = Risk Free Rate + Beta * Market Risk
Premium
Cost of Equity = 4.10% + 1.87 * 5.50%
Cost of Equity = 14.39%
WACC = (Weight of Debt * After Tax Cost of Debt) + (Weight of
Preferred Stock * Cost of Preferred Stock) + (Weight of Equity *
Cost of Equity)
WACC = (0.46 * 4.74%) + (0.11 * 11.08%) + (0.43 * 14.39%)
WACC = 9.59%
Answer to Part 5.
Weight of Debt = 0.47
Weight of Preferred Stock = 0.15
Weight of Common Stock = 0.38
After Tax Cost of Debt = 9.0% * (1 – 0.40)
After Tax Cost of Debt = 5.40%
Cost of Preferred Stock = Annual Dividend / Current Price *
100
Cost of Preferred Stock = $7.02 / $69.52 * 100
Cost of Preferred Stock = 10.10%
Cost of Equity = Risk Free Rate + Beta * Market Risk
Premium
Cost of Equity = 4.30% + 0.80 * 11.00%
Cost of Equity = 13.10%
WACC = (Weight of Debt * After Tax Cost of Debt) + (Weight of
Preferred Stock * Cost of Preferred Stock) + (Weight of Equity *
Cost of Equity)
WACC = (0.47 * 5.40%) + (0.15 * 10.10%) + (0.38 * 13.10%)
WACC = 9.03%