Question

Anderson Corporation has 1 million shares of common stock outstanding, 1/2 million shares of preferred stock, and 20,000 3.5% semiannual bonds outstanding. The common stock has a beta of 1.2. The corporate bond has a par value of $1,000 each and matures in 14 years. Currently the bonds are selling at 94% of their face values. The market risk premium is 9%. The risk-free rate is 3%. The common stock sells for $40 per share. The preferred stock sells for $75 per share and the preferred dividend is $6 per share. IF the corporate tax rate is 34%;

A) What is the after-tax cost of debt capital? Show formulas

B) What is the cost of common equity? Show formulas

C) What is Anderson's WACC? Show formulas

Answer 1

Firm’s Market Value Capital Structure

Capital	Calculation	Market Value Capital Structure Weights
Debt	[$1,88,00,000 / $9,63,00,000]	0.1952
Preferred Stock	[$,375,00,000 / $9,63,00,000]	0.3894
Equity	[$400,00,000 / $9,63,00,000]	0.4154

Market Value of each capital Structure

Debt = $1,88,00,000 [20,000 Bonds x $940 per bond]

Preferred Stock = $3,75,00,000 [500,000 Shares x $75 per share]

Equity = $4,00,00,000 [10,00,000 Shares x $40 per share]

Total Market Value = $9,63,00,000

After-Tax Cost of Debt

After-tax Cost of Debt

The After-tax Cost of Debt is the after-tax Yield to maturity of the Bond

The Yield to maturity of (YTM) of the Bond is calculated using financial calculator as follows (Normally, the YTM is calculated either using EXCEL Functions or by using Financial Calculator)

Variables	Financial Calculator Keys	Figure
Face Value [$1,000]	FV	1,000
Coupon Amount [$1,000 x 3.50 x ½]	PMT	17.50
Yield to Maturity [YTM]	1/Y	?
Time to Maturity [14 Years x 2]	N	28
Bond Price [-$1,000 x 94%]	PV	-940

We need to set the above figures into the financial calculator to find out the Yield to Maturity of the Bond. After entering the above keys in the financial calculator, we get the yield to maturity (YTM) on the bond = 4.07%

After Tax Cost of Debt = Yield to maturity x (1 – Tax Rate)

= 4.07% x (1 – 0.34)

= 4.07% x 0.66

= 2.69%

Cost of Preferred Stock

Cost of Preferred Stock = [Preferred Dividend / Selling Price] x 100

= [$6.00 / $75.00] x 100

= 8.00%

Cost of Common Equity

As per Capital Asset Pricing Model [CAPM], The cost of common equity is computed by using the following equation

The Cost of Common Equity = Risk-free Rate + [Beta x Market Risk Premium]

= 3.00% + [1.2 x 9.00%]

= 3.00% + 10.80%

= 13.80%

Anderson's WACC

Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of Preferred stock x Weight of preferred stock] + [Cost of equity x Weight of Equity]

= [2.69% x 0.1952] + [8.00% x 0.3894] + [13.80% x 0.4154]

= 0.52% + 3.12% + 5.73%

= 9.37%

“Hence, the Anderson's WACC will be 9.37%”