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Resources Corporation is estimating its WACC. Its target capital structure is 40% debt, 10% preferred stock,...

Resources Corporation is estimating its WACC. Its target capital structure is 40% debt, 10% preferred stock, and 50% common equity. Its bonds have an 8% coupon rate, paid semi-annually, a current maturity of 12 years, and sell for $1,080.29. The firm could sell, at par, $100 preferred stock which pays a 6.75% annual dividend (assume no flotation costs). Resources’ beta is 1.6, the risk-free rate [rRF] is 3%, and the market risk premium [RPM] is 5%. Resources is a constant-growth firm which just paid a dividend of $2.40, the common stock currently sells for $35.72 per share [Po], and has a growth rate of 4%. The firm’s marginal tax rate is 40 percent.

a) What is Resources’ component cost of debt [Kd]? Calculate Kd for the semi-annual coupon bond

b) What is Resources’ cost of preferred stock [Kp]?

c) What is Resources’ cost of common stock (Ks) using the CAPM approach?

d) What is the firm’s cost of common stock (Ks) using the DDM approach?

e) What is Resources’ WACC? (Use the average Ks derived under the CAPM(#6) & DDM(#7) approaches)

Please show how you arrived at the answers as well

Expert Solution

(a) Bond Coupon Rate = 8 % payable semi-annually,Par Value = $ 1000, Sale Price = $ 1080.29 and Current Maturity = 12 years

Let the YTM be 2r

Semi-Annual Coupon = 0.5 x 0.08 x 1000 = $ 40

Therefore, 1080.29 = 40 x (1/r) x [1-{1/(1+r)^(24)}] + 1000 / (1+r)^(24)

Using EXCEL's Goal Seek Function/hit and trial method/ a financial calculator to solve the above equation, we get:

r = 0.035 or 3.5 %

YTM = Before-Tax Cost of Debt = 3.5 x 2 = 7 %

Marginal Tax Rate = 40 % and Kd = (1-0.4) x 7 = 4.2 %

(b) Price of Preferred Stock = $ 100 and Annual Dividend Rate = 6.75 %

Annual Dividend = Annual Dividend Rate x Par Price = 0.0675 x 100 = $ 6.75

Kp = Annual Dividend / Current Price = 6.75 / 100 = 0.0675 or 6.75 %

(c) Beta = 1.6, Rf = 3 % and RPM = 5 %

Theerefore, using CAPM, Ke = 3 + 1.6 x 5 = 11 %

(d) Current DIvidend = D0 = $ 2.4, Current Stock Price = P0 = $ 35.72 and Growth Rate = g = 4 %

Ke = [(2.4 x 1.04) / 35.72] + 0.04 = (2.496/35.72) + 0.04 =0.10988 or 10.988 %

(e) Debt = 40 %, Preferred Stock = 10 % and Common Stock = 50 %

Average Ke = (11+10.988) / 2 = 10.99 %

WACC = (1-0.4) x 4.2 x 0.4 + 6.75 x 0.1 + 10.99 x 0.5 = 7.178 % ~ 7.18 %

jeff jeffy answered 1 year ago

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