Question

22. Fillips, Inc. is trying to estimate is cost of capital.

- Fillips believes that the appropriate value of debt and equity is debt: $7000 and equity $13000

- Fillips has a tax rate of 30%.

- Fillips’ bonds currently trade in the market for a price of $835. These $1,000 par value bonds have a coupon rate of 10% (annual coupon payments) and they mature in 28 years.

- Fillips’ common stock trades for $22 per share. The dividend just paid by Fillips was $3.15 (D₀ = 3.15) and future dividends are expected to grow at a rate of 4% per year forever.

Assume that Fillips’ common stock is priced fairly using CAPM model.

What is Fillips’ cost of capital (WACC)?

a)14.32%

b)15.24%

c)18.89%

d)11.27%

Answer 1

Weighted average cost of capital (WACC) = [(S/S+B)*Rs + (B/S+B)*Rb(1-tc)]
	S = equity, B = debt, Rs = Cost of equity, Rb = cost of debt,
	tc = corporations tax rate
	B = 7000
	S = 13000
Find the cost of debt and the cost of equity:
Par/Face value	1000
Annual Coupon rate	0.1
Annual coupon	100
Present Value = Future value/ ((1+r)^t)
where r is the interest rate and t is the time period
price of the bond = sum of present values of future cash flows
price of the bond	835
Use excel to find r
r	0.1208
t	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15	16	17	18	19	20	21	22	23	24	25	26	27	28
future cash flow	100	100	100	100	100	100	100	100	100	100	100	100	100	100	100	100	100	100	100	100	100	100	100	100	100	100	100	1100
present value	89.22198	79.60562	71.02572	63.37056	56.54047	50.44653	45.00939	40.15827	35.83001	31.96824	28.5227	25.44852	22.70567	20.25845	18.07499	16.12687	14.38871	12.83789	11.45422	10.21969	9.118207	8.135445	7.258605	6.476272	5.778258	5.155477	4.599819	45.14454
sum of present values	835
The cost of debt Rb = 12.08%.
According to the dividend growth model.
P0 = D0/(R-g)
D0 = 3.15

P0 = 22
g = .04
22 = 3.15/(R-.04)
R - .04 = 3.15/22
R = .183182
Rs (cost of equity) = 18.32%
WACC = (13000/20000)*.1832 + (7000/20000)*(.1208)*(1-.30)
WACC = .65*(.1832) + .35*(.1208)*(.70)
WACC = .1487
WACC = 14.87%
b) 15.24%.