Question

Using the following information for RZX Corp. and the general economy, compute the weighted average cost of capital for RZX Corp:

• – The YTM on 20-year U.S. Treasury bonds is 3.5%. The market risk premium is 5.5%.

• – RZX has 6.75% coupon bonds that were issued five years ago, mature in 20 years,

  make semiannual interest payments, and currently sell for $1,036.60.

• – The current price of the firm’s 6.80%, $100.00 par value, quarterly dividend, perpetual

  preferred stock is $104.50.

• – RZX’s common stock is currently selling for $40 per share. It just paid a $2.95 dividend, and

  these dividends are expected to grow at a constant annual rate of 6% in the foreseeable future. Assume the risk-free rate is 7% and the market risk premium is 6%. For the bond- yield-plus-risk-premium approach, the firm uses a risk premium of 5%.

• – RZX common stock has a beta of 1.25.

- RZX has a marginal corporate tax rate of 35%

– The firm’s CFO suggests that its target capital structure is 15% debt, 5% preferred stock, and 60% equity.

1. Using WACC compute the weighted average cost of capital.

2. What is the after tax cost of debt for RZX.

3. What is the cost of equity for RZX Corp? Use CCAP and WACC. Assumer the equity risk premium is 4.5%

Answer 1

	STEPS TO ESTIMATE WEIGHTED AVERAGE COST OF CAPITAL
	STEP1	Bonds:
		Calculated cost of Bond by determining Yield To Maturity(YTM) and taking into account tax shield on interest
		Calculate total Market Value of bond
	STEP2	PREFERENCE SHARES:
		Calculated cost of Preference shares from dividend payments required
		Calculate total Market Value of Preference shares
	STEP3	COMMON STOCK
		Calculated cost of commonstock by determining required returns
		Calculate total Market Value of Common Stock
	STEP4	Calculate total market value of capital
		Calculate weight of Bond, preference shares and Common stock in total capital
	STEP5	Calculate Weighted Average Cost of Capital(WACC)
		WACC=Wb*Cb+Wp*Cp+We*Ce
		Wb=Weight of Bond in the total capital
		Wp=Weight of Preference Shares in the totalcapital
		We=Weight of Common Shares in the total capital
		Cb=Cost of bond
		Cp=Cost of Preference shares
		Ce=Cost of Common Shares
		AFTER TAX COSTS:
		Debt
		Face value of each Bond	$1,000
		Coupon Rate	6.75%
	Pmt	Semi annual Coupon Payment=1000*6.75%*(1/2)	$33.75
	Nper	Number of payments	40	(20*2)
	Pv	Current marke Value of each Bond	$1,036.60
	Fv	Amount to paid at maturity	$1,000
	RATE	Semi annual Yield To Maturity(Using RATE function of excel with Nper=40,Pmt=33.75,v=-1036.60,Fv=1000)(Excel command: RATE(40,33.75,-1036.60,1000)	3.21%
		Annual effective rate =(1.0321^2)-1=	6.52%
	Cb	After Tax Cost of Bond =6.52*(1-Tax Rate)=6.52*(1-0.35)=	4.24%
		Preference shares
		QuarterlyDividend=(100*6.8%)*(1/4)	$1.70
		Market Value=$104.50
		Quarterly required return=1.7/104.50=	0.0163
		Required Annual return =(1.0163^4)-1=	6.68%
	Cp	Cost of Preference Shares=1.2/20=	6.68%
		Common Shares:
		D1=Next Years dividend=$2.95*1.06=	$3.13
		g=Dividend Growth Rate=6%=0.06
		P0=Market Price =$40
		R=Required rate of return
		P0=D1/(R-g)=$40
		R-g=D1/40
		Required Return =(3.13/40)+0.06=	13.83%
		Cost of CommonStock=13.83%
		CAPM EQUATION:
		Rs=Rf+Beta*(Rm-Rf)
		Rf=riskfree rate=7%, Rm-Rf=Market risk Premium=6%, Beta=1.25
		Rs=7+1.25*6=	14.50%
	Ce	Cost of Equity =14.50%
		Target Capital Structure
		Wb=Weight of Debt in the total capital	0.15
		Wp=Weight of Preference Shares in the total capital	0.05
		We=Weight of Common Shares in the total capital	0.6
		After Tax Weighted average Cost of Capital:
		WACC=Wb*Cb+Wp*Cp+We*Ce=4.24*0.15+6.68*0.05+14.5*0.60=	9.67%