Question

You are given the following information concerning Parrothead Enterprises:

Debt:		9,700 7.2 percent coupon bonds outstanding, with 23 years to maturity and a quoted price of 105.75. These bonds pay interest semiannually.
Common stock:		260,000 shares of common stock selling for $65.20 per share. The stock has a beta of .92 and will pay a dividend of $3.40 next year. The dividend is expected to grow by 5.2 percent per year indefinitely.
Preferred stock:		8,700 shares of 4.60 percent preferred stock selling at $94.70 per share.
Market:		An expected return of 11.3 percent, a risk-free rate of 5.10 percent, and a 30 percent tax rate.

What is the firm's cost of each form of financing? (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Aftertax cost of debt	_____%
Cost of preferred stock	_____%
Cost of equity	_____%

Calculate the WACC for the company. (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

WACC ______ %

Answer 1

Debt:

Number of bonds outstanding = 9,700
Face Value = $1,000

Current Price = 105.75% * $1,000
Current Price = $1,057.50

Value of Debt = 9,700 * $1,057.50
Value of Debt = $10,257,750

Annual Coupon Rate = 7.20%
Semiannual Coupon Rate = 3.60%
Semiannual Coupon = 3.60% * $1,000
Semiannual Coupon = $36

Time to Maturity = 23 years
Semiannual Period to Maturity = 46

Let semiannual YTM be i%

$1,057.50 = $36 * PVIFA(i%, 46) + $1,000 * PVIF(i%, 46)

Using financial calculator:
N = 46
PV = -1057.50
PMT = 36
FV = 1000

I = 3.353%

Semiannual YTM = 3.353%
Annual YTM = 2 * 3.353%
Annual YTM = 6.706%

Before-tax Cost of Debt = 6.706%
After-tax Cost of Debt = 6.706% * (1 - 0.30)
After-tax Cost of Debt = 4.69%

Preferred Stock:

Number of shares outstanding = 8,700
Current Price = $94.70

Annual Dividend = 4.60% * $100
Annual Dividend = $4.60

Value of Preferred Stock = 8,700 * $94.70
Value of Preferred Stock = $823,890

Cost of Preferred Stock = Annual Dividend / Current Price
Cost of Preferred Stock = $4.60 / $94.70
Cost of Preferred Stock = 4.86%

Equity:

Number of shares outstanding = 260,000
Current Price = $65.20

Value of Common Stock = 260,000 * $65.20
Value of Common Stock = $16,952,000

Using CAPM:

Cost of Equity = Risk-free Rate + Beta * (Market Return - Risk-free Rate)
Cost of Equity = 5.10% + 0.92 * (11.30% - 5.10%)
Cost of Equity = 10.80%

Using DDM:

Cost of Equity = Expected Dividend / Current Price + Growth Rate
Cost of Equity = $3.40 / $65.20 + 0.0520
Cost of Equity = 0.1041 or 10.41%

Average Cost of Equity = (10.80% + 10.41%) / 2
Average Cost of Equity = 10.61%

Value of Firm = Value of Debt + Value of Preferred Stock + Value of Equity
Value of Firm = $10,257,750 + $823,890 + $16,952,000
Value of Firm = $28,033,640

Weight of Debt = $10,257,750 / $28,033,640
Weight of Debt = 0.3659

Weight of Preferred Stock = $823,890 / $28,033,640
Weight of Preferred Stock = 0.0294

Weight of Common Stock = $16,952,000 / $28,033,640
Weight of Common Stock = 0.6047

WACC = Weight of Debt * After-tax Cost of Debt + Weight of Preferred Stock * Cost of Preferred Stock + Weight of Equity * Cost of Equity
WACC = 0.3659 * 4.69% + 0.0294 * 4.86% + 0.6047 * 10.61%
WACC = 8.27%