Question

You are given the following information concerning Around Town Tours: Debt: 8,500, 8 percent coupon bonds outstanding, with 15 years to maturity, face value of 1000, and price at 1026. These bonds pay interest semiannually. Common stock: 260,000 shares of common stock selling for $76 per share. The stock has a beta of 0.92. Preferred stock: 7,500 shares of 5 percent preferred stock with face value of $100, selling at $88 per share. Market: A 13.2 percent expected return, a 4.5 percent risk-free rate, and a 34 percent tax rate. Questions: 1) what is the value, weight and cost of debt? 2) what is the value, weight and cost of equity? 3) What is the value weight and cost of preferred? 4) What is the weighted average cost of capital (WACC)?

Answer 1

1

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

MV of equity=76*260000

=19760000

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

MV of Bond=1000*8500*1.026

=8721000

MV of Preferred equity=Price*number of shares outstanding

MV of Preferred equity=88*7500

=660000

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

=19760000+8721000+660000

=29141000

Weight of debt = MV of Bond/MV of firm

Weight of debt = 8721000/29141000

W(D)=0.2993

Cost of debt

K = Nx2

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

k=1

K =15x2

1026 =∑ [(8*1000/200)/(1 + YTM/200)^k]     +   1000/(1 + YTM/200)^15x2

k=1

YTM = 11.268

2

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

MV of equity=76*260000

=19760000

Weight of equity = MV of Equity/MV of firm

Weight of equity = 19760000/29141000

W(E)=0.6781

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (expected return on the market - risk-free rate)

Cost of equity% = 4.5 + 0.92 * (13.2 - 4.5)

Cost of equity% = 12.5

3

MV of Preferred equity=Price*number of shares outstanding

MV of Preferred equity=88*7500

=660000

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

Weight of preferred equity = 660000/29141000

W(PE)=0.0226

cost of preferred equity

cost of preferred equity = Preferred dividend/price*100

cost of preferred equity = 5/88*100

=5.68

4

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

After tax cost of debt = 11.268*(1-0.34)

= 7.43688

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

WACC=7.44*0.2993+12.5*0.6781+5.68*0.0226

WACC =10.83%