Question

The VWX Inc. has 100,000 bonds outstanding (1000$ each) that are selling at 100%. The bonds are yielding 7.5 percent. The company also has 1 million shares of preferred stock outstanding currently yielding 18.75 percent. It has also 5 million shares of common stock outstanding. The preferred stock sells for $56 per share and the common stock sells for $38 a share. The expected return on the common stock is 13.8%. The corporate tax rate is 34 percent. What is VWX Inc.’s weighted average cost of capital?

b) The WACC formula implies that debt is “cheaper” than equity, that a firm with more debt could use lower discount rate. Does this make sense? Explain briefly.

Answer 1

The VWX Inc. has 100,000 bonds outstanding (1000$ each) that are selling at 100%. The bonds are yielding 7.5 percent. The company also has 1 million shares of preferred stock outstanding currently yielding 18.75 percent. It has also 5 million shares of common stock outstanding. The preferred stock sells for $56 per share and the common stock sells for $38 a share. The expected return on the common stock is 13.8%. The corporate tax rate is 34 percent. What is VWX Inc.’s weighted average cost of capital?

WACC = ( cost of debt * weight of debt ) + ( cost of preferred stock * weight of preferred stock ) + ( cost of equity * weight of equity )

Here,

WACC = Weighted average cost of capital

Cost of debt = Before tax cost of debt ( 1 - tax rate )

Before tax cost of debt = 7.5%

Tax rate = 34% = 0.34

Cost of debt = 7.4 ( 1 - 0.35 ) = 7.4 * 0.65   = 4.81%

Cost of preferred stock = 18.75%

Cost of common equity = expected return = 13.80%

Next calculate the weight of each components in capital structure

Company capital structure include the market value

Debt = 100000 * 1000 = 100000000

Preferred stock = 1000000 * 56 = 56000000

Equity = 5000000 * 38 = 190000000

Total market value = 100000000 + 56000000 + 190000000 = 346000000

Calculate each weight

Weight of debt = 100000000 / 346000000 = 0.289 = 28.90%

weight of preferred stock = 56000000 / 346000000 = 0.1618 = 16.19%

weight of equity = 190000000 / 346000000 = 0.5491 54.91%

Then calculate WACC

WACC = ( 4.81 * 28.90% ) + ( 18.75 * 16.19% ) + ( 13.80 * 54.91% )

WACC = 1.39009 + 3.035625 + 7.57758   

WACC = 12%

b) The WACC formula implies that debt is “cheaper” than equity, that a firm with more debt could use lower discount rate. Does this make sense? Explain briefly.

This is possible to a firm could use more debt, and the resulted discount rate is lower than any other cost fund. The reason for lower the rate or cost of debt is the tax shield. Because the interest is a taxable expenses.

But there is a optimal level to raise fund through debt. Beyond that level the overall cost of capital will increase, because the company risk level are high through default risk. So this will lead to increase the potential investors required rate.

Beyond that level the company Degree of leverage will increase. It will affect the firm badly.