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(WACC) A company has common stock, preferred shares, and debt outstanding. As of today, the common...

  1. (WACC) A company has common stock, preferred shares, and debt outstanding. As of today, the common stock is valued at $10 per share, with 2 million shares outstanding. It has a beta of 5, and market return is estimated to be 4% while treasury bills offer 1.5% risk-free rate. The preferred stock is valued at $15 per share, which pays dividend of $2 each year at a constant growth rate of 3%. Preferred stocks have 5 million shares outstanding. Finally, debt has a market value of $4 million dollars and pays an interest rate of 5%. Tax rate is 40%. Calculate WACC.

Show formula and work using hand-only. Do not use excel.

Solutions

Expert Solution

We would calculate the cost for each of the finance obtained.

Formula to calculate cost of equity using CAPM model

Ke = Rf + Beta*(Rm-Rf)

where Ke = cost of equity

Rf = risk free rate

Rm = market interest rate

Calculation of cost of equity

Ke = 0.015 + 5*(0.04-0.015)

Ke = 0.015 + 0.125

Ke = 0.015 + 0.125

Ke = 14%

The cost of equity is 14%

Formula to calculate cost of preferred stock

Kp = (D0*(1+g)/P) + g

where Kp = Cost of preference shares

D0 is the dividend paid

g = growth rate

P = price of preferred stock

Calculation of cost of preferred stock

Kp = (2*(1.03))/15 + 0.03

Kp = 2.06/15 + 0.03

Kp = 0.1373 + 0.03

Kp = 16.73%

The cost of preference share is 16.73%

Formula to calculate after tax cost of debt

After tax cost of debt = Interest rate*(1-t)

Calculation of after tax cost of debt

After tax cost of debt = 0.05*(1-0.40)

After tax cost of debt = 3%

The after tax cost of debt is 3%

Calculation of Weights of each financing option

Value

Weights

Equity (2000000*10)

$20,000,000

20.20%

2000000/99000000

Preference share (5000000*15)

$75,000,000

75.76%

7500000/99000000

Debt

$4,000,000

4.04%

4000000/99000000

Total finance

$99,000,000

100.00%

Formula to calculate WACC

WACC = We*Ke + Wp*Kp + Wd*Kd

where We = weight of equity

Ke = Cost of equity

Wp = weight of preferred stock

Kp = cost of preferred stock

Wd = weight of debt

Kd = cost of debt

Calculation of WACC

WACC = (0.2020*0.14)+(0.7576*0.1673)+(0.0404*0.03)

WACC = 15.63%

The WACC of the company is 15.63%

jeff jeffy answered 2 years ago
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