Question

Growth​ Company's current share price is $20.10 and it is expected to pay a $0.85 dividend per share next year. After​ that, the​ firm's dividends are expected to grow at a rate of 3.5% 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 $2.10 per share fixed dividend. If this stock is currently priced at $28.00​, 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 6.4%. What is Growth​ Company's cost of​ debt?

d. Growth Company has 4.7 million common shares outstanding and 1.3 million preferred shares​outstanding, and its equity has a total book value of $50.1 million. Its liabilities have a market value of $19.8 million. 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 a 35% 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)

20.1 = 0.85/ (Cost of equity - 0.035)

Cost of equity% = 7.73

b

cost of preferred equity

cost of preferred equity = Preferred dividend/price*100

cost of preferred equity = 2.1/(28)*100

=7.5

c

Cost of debt = YTM of new debt = 6.4%
d

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

MV of equity=20.1*4700000

=94470000

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

MV of Bond=1000*19800*1

=19800000

MV of Preferred equity=Price*number of shares outstanding

MV of Preferred equity=28*1300000

=36400000

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

=94470000+19800000+36400000

=150670000

e

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

After tax cost of debt = 6.4*(1-0.35)

= 4.16

Weight of equity = MV of Equity/MV of firm

Weight of equity = 94470000/150670000

W(E)=0.627

Weight of debt = MV of Bond/MV of firm

Weight of debt = 19800000/150670000

W(D)=0.1314

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

Weight of preferred equity = 36400000/150670000

W(PE)=0.2416

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

WACC=4.16*0.1314+7.73*0.627+7.5*0.2416

WACC =7.21%