Question

In: Finance

Match the Weighted Average Cost of Capital to each of the scenarios given for ABC Corporation....

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%

Solutions

Expert Solution

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%


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