Question

You are given the following information for Watson Power Co. Assume the company’s tax rate is 23 percent.

Debt:	18,000 6.7 percent coupon bonds outstanding, $1,000 par value, 25 years to maturity, selling for 108 percent of par; the bonds make semiannual payments.
Common stock:	510,000 shares outstanding, selling for $69 per share; the beta is 1.20.
Preferred stock:	22,500 shares of 4.5 percent preferred stock outstanding, currently selling for $90 per share. The par value is $100 per share.
Market:	5 percent market risk premium and 5.6 percent risk-free rate

Answer 1

MV of equity=Price of equity*number of shares outstanding

MV of equity=69*510000

=35190000

MV of Bond=Par value*bonds outstanding*%age of par

MV of Bond=1000*18000*1.08

=19440000

MV of Preferred equity=Price*number of shares outstanding

MV of Preferred equity=90*22500

=2025000

MV of firm = MV of Equity + MV of Bond+ MV of Preferred equity

=35190000+19440000+2025000

=56655000

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (Market risk premium)

Cost of equity% = 5.6 + 1.2 * (5)

Cost of equity% = 11.6

Cost of debt

K = Nx2

Bond Price =∑ [(Semi Annual Coupon)/(1 + YTM/2)^k]     +   Par value/(1 + YTM/2)^Nx2

k=1

K =25x2

1080 =∑ [(6.7*1000/200)/(1 + YTM/200)^k]     +   1000/(1 + YTM/200)^25x2

k=1

YTM = 6.0737887666

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

After tax cost of debt = 6.0737887666*(1-0.23)

= 4.676817350282

cost of preferred equity

cost of preferred equity = Preferred dividend/price*100

cost of preferred equity = 4.5/90*100

=5

Weight of equity = MV of Equity/MV of firm

Weight of equity = 35190000/56655000

W(E)=0.6211

Weight of debt = MV of Bond/MV of firm

Weight of debt = 19440000/56655000

W(D)=0.3431

Weight of preferred equity = MV of preferred equity/MV of firm

Weight of preferred equity = 2025000/56655000

W(PE)=0.0357

WACC=after tax cost of debt*W(D)+cost of equity*W(E)+Cost of preferred equity*W(PE)

WACC=4.68*0.3431+11.6*0.6211+5*0.0357

WACC% = 8.99