Question

A firm has the following capital structure. Assume the company's tax rate is 25%

Debt: the firm has 5,000 6% coupon bonds outstanding $1000 par value, 11 years to maturity selling for 103 percent of par: the bonds make semiannual payments.

Common Stock: The firm has 375000 shares outstanding, selling for $65 per share; the beta is 1.08

Preferred Stock: The firm has 15,000 shares of 5% preferred stock outstanding, currently selling for $75 per share.

There is currently a 7% market risk premium and 2.5% risk-free rate

What is the company's weight of debt?

What is the company's weight of equity?

What's the company's weight of preferred?

What is the company's pretax cost of debt?

What is the company's cost of equity?

What is the company's cost of preferred?

What is the company's weighted average cost of capital?

Answer 1

Firm’s Market Value Capital Structure

Capital	Calculation	Market Value Capital Structure Weights
Debt	[$51,50,000 / $306,50,000]	0.1680
Preferred Stock	[$11,25,000 / $306,50,000]	0.0367
Equity	[$243,75,000 / $306,50,000]	0.7953

Market Value of each capital Structure

Debt = $51,50,000 [5,000 x ($1,000 x 103%)]

Preferred Stock = $11,25,000 [15,000 x $75]

Equity = $243,75,000 [375,000 x $65]

Total Market Value = $306,50,000

Company's weight of debt = 0.1680 or 16.80%

Company's weight of equity = 0.7953 or 79.53%

Company's weight of preferred = 0.0367 or 3.67%

Pre-tax Cost of Debt

The After-tax Cost of Debt is the after-tax Yield to maturity of the Bond

The Yield to maturity of (YTM) of the Bond is calculated using financial calculator as follows (Normally, the YTM is calculated either using EXCEL Functions or by using Financial Calculator)

Variables	Financial Calculator Keys	Figure
Face Value [$1,000]	FV	1,000
Coupon Amount [$1,000 x 6% x ½]	PMT	30
Yield to Maturity [YTM]	1/Y	?
Time to Maturity [11 Years x 2]	N	22
Bond Price [-$1,000 x 103%]	PV	-1,030

We need to set the above figures into the financial calculator to find out the Yield to Maturity of the Bond. After entering the above keys in the financial calculator, we get the yield to maturity (YTM) on the bond = 5.63%

Company's pre-tax cost of debt = 5.63%

Company's cost of equity

Company's cost of equity = Risk-free Rate + (Beta x Market Risk Premium]

= 2.50% + [1.08 x 7.00%]

= 2.50% + 7.56%

= 10.06%

Company's cost of preferred

Cost of Preferred Stock = Preferred Dividend / Selling Price of the Share

= [$5.00 / $75.00] x 100

= 6.67%

Company's weighted average cost of capital

Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of Preferred stock x Weight of preferred stock] + [Cost of equity x Weight of Equity]

= [5.63%(1 – 0.25) x 0.1680] + [6.67% x 0.367] + [10.06% x 0.7953]

= 0.71% + 0.24% + 8.00%

= 8.95%