Question

- A corporation has 10,000 bonds outstanding with 6% annual coupon rate, 8 years to maturity, $1,000 face value, and $1,100 market price.

- The company’s 500,000 shares of common stock sell for $25 per share and have a beta of 1.5. The risk-free rate is 4%, and the market risk premium is 8%.

- The company’s 100,000 shares of preferred stock pay a $3 annual dividend, and sell for $30 per share.

- Assuming a 40% tax rate, what is the company’s weighted average cost of capital ?

Step 1: Component costs of capital

Step 2: Capital structure weights

Step 3: WACC

Please Do not use excel.

Show work please.

Answer 1

1.

Cost of equity = risk free rate + market risk premium * beta

= 4% + 8%*1.5

= 16%

Cost of Preferred Stock = Annual Dividend / Price *100

= $ 3/$ 30

= 10%

The Approximate Yield to Maturity Formula =[Coupon + ( Face Value - Market Price) / Number of years to maturity] / [( Face Value + Market Price)/2 ] *100

= [$ 60 + ( $ 1,000- $ 1100 ) /8] /[( $ 1,000+ $ 1100 )/2] *100

= 47.5/1050*100

= 4.523809524%

Note : Coupon = Rate * Face Value

= 6% * $ 1,000

= $ 60

Since this formula gives an approximate value, the financial calculators can be used alternatively.

where,

Par Value = $ 1,000

Market Price = $  1100

Annual rate = 6% and

Maturity in Years = 8 Years

Hence the yield to maturity = 4.48%

After tax cost of debt = yield to maturity * (1- tax rate)

= 4.48%* (1-40%)

= 2.688%

2. Value of Bond = 10000 Bonds * $ 1100

Value of Common Stock = 500,000 Shares * $ 25

Preferred Stock = 100,000 Shares * $ 30

3. weighted average cost of capital (WACC ) = (Cost of Debt * Weight of Debt) + (Cost of Equity * Weight of Equity)+ (Cost of Preferred Stock * Weight of Preferred Stock )

= 9.80%

	Value	Weight(Value / Total)	Cost	Weight * Cost
Bond	11000000	0.41509434	2.688%	1.115773585
Equity	12500000	0.471698113	16%	7.547169811
Preferred Stock	3000000	0.113207547	10%	1.132075472
Total	26500000		WACC	9.80

Answer = 9.80%