Question

Debt: 5,500 7.5 percent coupon bonds outstanding, $1,000 par value, 21 years to maturity, selling for 105 percent of par; the bonds make semiannual payments. Common stock: 132,000 shares outstanding, selling for $57 per share; the beta is 1.11. Preferred stock: 18,000 shares of 6.5 percent preferred stock outstanding, currently selling for $106 per share. Market: 8.5 percent market risk premium and 6 percent risk-free rate. Assume the company's tax rate is 31 percent. What is the WAAC?

Answer 1

Firm’s Market Value Capital Structure

Capital	Calculation	Market Value Capital Structure Weights
Debt	[$57,75,000 / $ 1,52,07,000]	0.3798
Preferred Stock	[$19,08,000 / $ 1,52,07,000]	0.1254
Equity	[$75,24,000 / $ 1,52,07,000]	0.4948

Market Value of each capital Structure

Debt = $57,75,00 [5,500 x ($1,000 x 105%)]

Preferred Stock = $19,08,000 [18,000 x $106]

Equity = $75,24,000 [132,000 x $57]

Total Market Value = $1,52,07,000

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 7.50% x ½]	PMT	37.50
Yield to Maturity [YTM]	1/Y	?
Time to Maturity [21 Years x 2]	N	42
Bond Price [-$1,000 x 105%]	PV	-1,050

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 = 7.04%

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

= 7.04% x (1 – 0.31)

= 7.04% x 0.69

= 4.86%

Cost of Preferred Stock

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

= [$6.50 / $106] x 100

= 6.13%

Cost of Equity

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

= 6.00% + [1.11 x 8.50%]

= 6.00% + 9.44%

= 15.44%

Weighted Average Cost of Capital (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]

= [4.86% x .3798] + [6.13% x .1254] + [15.44% x 0.4948]

= 1.84% + 0.77% + 7.64%

= 10.25%

“Hence, the Company’s WACC will be 10.25%”