Question

Saunders Investment Bank has the following financing outstanding.

  

Debt:	20,000 bonds with a coupon rate of 10 percent and a current price quote of 108.0; the bonds have 20 years to maturity. 190,000 zero coupon bonds with a price quote of 19.5 and 30 years until maturity.
Preferred stock:	110,000 shares of 8 percent preferred stock with a current price of $83, and a par value of $100.
Common stock:	2,200,000 shares of common stock; the current price is $69, and the beta of the stock is 1.35.
Market:	The corporate tax rate is 40 percent, the market risk premium is 7 percent, and the risk-free rate is 4 percent.

what is company's WACC ?

Answer 1

Debt:

1^st Issue of Bonds:

Number of bonds outstanding = 20,000
Par Value = $1,000

Current Price = 108.0% * $1,000
Current Price = $1,080

Market Value = Number of bonds outstanding * Current Price
Market Value = 20,000 * $1,080
Market Value = $21,600,000

Annual Coupon Rate = 10%
Semiannual Coupon Rate = 5%
Semiannual Coupon = 5% * $1,000
Semiannual Coupon = $50

Time to Maturity = 20 years
Semiannual Period to Maturity = 40

Let Semiannual YTM be i%

$1,080 = $50 * PVIFA(i%, 40) + $1,000 * PVIF(i%, 40)

Using financial calculator:
N = 40
PV = -1080
PMT = 50
FV = 1000

I = 4.56%

Semiannual YTM = 4.56%
Annual YTM = 2 * 4.56%
Annual YTM = 9.12%

Before-tax Cost of Debt = 9.12%
After-tax Cost of Debt = 9.12% * (1 - 0.40)
After-tax Cost of Debt = 5.472%

2^nd Issue of Bonds:

Number of bonds outstanding = 190,000
Par Value = $1,000

Current Price = 19.50% * $1,000
Current Price = $195

Market Value = Number of bonds outstanding * Current Price
Market Value = 190,000 * $195
Market Value = $37,050,000

Time to Maturity = 30 years
Semiannual Period to Maturity = 60

Let Semiannual YTM be i%

$195 = $1,000 * PVIF(i%, 60)

Using financial calculator:
N = 60
PV = -195
PMT = 0
FV = 1000

I = 2.76%

Semiannual YTM = 2.76%
Annual YTM = 2 * 2.76%
Annual YTM = 5.52%

Before-tax Cost of Debt = 5.52%
After-tax Cost of Debt = 5.52% * (1 - 0.40)
After-tax Cost of Debt = 3.312%

Total Market Value of Debt = $21,600,000 + $37,050,000
Total Market Value of Debt = $58,650,000

Weight of 1^st Issue of Debt = $21,600,000 / $58,650,000
Weight of 1^st Issue of Debt = 0.3683

Weight of 2^nd Issue of Debt = $37,050,000 / $58,650,000
Weight of 2^nd Issue of Debt = 0.6317

Estimated After-tax Cost of Debt = 0.3683 * 5.472% + 0.6317 * 3.312%
Estimated After-tax Cost of Debt = 4.108%

Preferred Stock:

Number of shares outstanding = 110,000
Current Price = $83
Annual Dividend = 8% * $100 = $8

Value of Preferred Stock = 110,000 * $83
Value of Preferred Stock = $9,130,000

Cost of Preferred Stock = Annual Dividend / Current Price
Cost of Preferred Stock = $8 / $83
Cost of Preferred Stock = 9.639%

Equity:

Number of shares outstanding = 2,200,000
Current Price = $69

Value of Common Stock = 2,200,000 * $69
Value of Common Stock = $151,800,000

Cost of Common Equity = Risk-free Rate + Beta * Market Risk Premium
Cost of Common Equity = 4% + 1.35 * 7%
Cost of Common Equity = 13.45%

Value of Firm = Value of Debt + Value of Preferred Stock + Value of Common Stock
Value of Firm = $58,650,000 + $9,130,000 + $151,800,000
Value of Firm = $219,580,000

Weight of Debt = $58,650,000 / $219,580,000
Weight of Debt = 0.2671

Weight of Preferred Stock = $9,130,000 / $219,580,000
Weight of Preferred Stock = 0.0416

Weight of Common Stock = $151,800,000 / $219,580,000
Weight of Common Stock = 0.6913

WACC = Weight of Debt*After-tax Cost of Debt + Weight of Preferred Stock*Cost of Preferred Stock + Weight of Common Stock*Cost of Common Stock
WACC = 0.2671 * 4.108% + 0.0416 * 9.639% + 0.6913 * 13.450%
WACC = 10.80%