Question

Growth​ Company's current share price is $ 20.15and it is expected to pay a $ 1.15 dividend per share next year. After​ that, the​firm's dividends are expected to grow at a rate of 3.9 % per year.

a. What is an estimate of Growth​Company's cost of​ equity?

b. Growth Company also has preferred stock outstanding that pays a $ 2.25 per share fixed dividend. If this stock is currently priced at $ 27.95 what is Growth​Company's cost of preferred​ stock?

c. Growth Company has existing debt issued three years ago with a coupon rate of 5.9 % The firm just issued new debt at par with a coupon rate of 6.1 % What is Growth​ Company's cost of​ debt?

d. Growth Company has 4.8million common shares outstanding and 1.3million preferred shares​ outstanding, and its equity has a total book value of $ 50.0million. Its liabilities have a market value of $20.2million. If Growth​ Company's common and preferred shares are priced as in parts​(a​)and ​(b​),what is the market value of Growth​Company's assets?

e. Growth Company faces a35 % tax rate. Given the information in parts (a​)through​(d​),and your answers to those​ problems, what is Growth​ Company's WACC?

​Note: Assume that the firm will always be able to utilize its full interest tax shield.

Answer 1

a

Cost of equity

As per DDM

Price = Dividend in 1 year/(cost of equity - growth rate)

20.15 = 1.15/ (Cost of equity - 0.039)

Cost of equity% = 9.61

b

cost of preferred equity

cost of preferred equity = Preferred dividend/price*100

cost of preferred equity = 2.25/27.95*100

=8.05

c

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

After tax cost of debt = 6.1*(1-0.35)

= 3.965

d

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

MV of equity=20.15*4800000

=96720000

MV of Bond=MV of liabilities = 20200000

MV of Preferred equity=Price*number of shares outstanding

MV of Preferred equity=27.95*1300000

=36335000

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

=96720000+20200000+36335000

=153255000

e

Weight of equity = MV of Equity/MV of firm

Weight of equity = 96720000/153255000

W(E)=0.6311

Weight of debt = MV of Bond/MV of firm

Weight of debt = 20200000/153255000

W(D)=0.1318

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

Weight of preferred equity = 36335000/153255000

W(PE)=0.2371

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

WACC=3.97*0.1318+9.61*0.6311+8.05*0.2371

WACC =8.5%