Question

Phillips Equipment has 6,500 bonds outstanding that are selling at 96.5 percent of par. Bonds with similar characteristics are yielding 6.7 percent, pretax. The company also has 48,000 shares of 5.5 percent preferred stock and 75,000 shares of common stock outstanding. The preferred stock sells for $64 a share. The common stock has a beta of 1.32 and sells for $41 a share. The preferred stock has a stated value of $100. The U.S. Treasury bill is yielding 2.2 percent and the return on the market is 10.6 percent. The corporate tax rate is 21 percent. What is the weighted average cost of capital?

9.30 percent

8.09 percent

10.18 percent

8.64 percent

Please show work, thank you!

Answer 1

Assuming face value of bond to be $1,000

Price of bond = 0.965 * 1000 = 965

Market value of bond = 6,500 * 965 = 6,272,500

Market value of preferred stock = 48,000 * 64 = 3,072,000

Market value of common stock = 75,000 * 41 = 3,075,000

Total market value = 6,272,500 + 3,072,000 + 3,075,000 = 12,419,500

Annual preferred dividend = 0.055 * 100 = 5.5

Cost of preferred stock = (Annual dividend / price) * 100

Cost of preferred stock = (5.5 / 64) * 100

Cost of preferred stock = 8.5938%

Cost of equity = Risk free rate + beta (market return - risk free rate)

Cost of equity = 0.022 + 1.32 (0.106 - 0.022)

Cost of equity = 0.13288 or 13.288%

Weighted average cost of capital = Weight of debt*after tax cost of debt + weight of preferred stock*cost of preferred stock + weight of equity*cost of equity

Weighted average cost of capital = (6,272,500 / 12,419,500)*0.067*(1 - 0.21) + (3,072,000 / 12,419,500)*0.085938 + (3,075,000 / 12,419,500)*0.13288

Weighted average cost of capital = 0.02673 + 0.02126 + 0.0329

Weighted average cost of capital = 0.0809 or 8.09%