Question

Information on Gerken Power Co., is shown below. Assume the company’s tax rate is 40 percent.

Debt:		8,900 8.2 percent coupon bonds outstanding, $1,000 par value, 21 years to maturity, selling for 103 percent of par; the bonds make semiannual payments.
Common stock:		214,000 shares outstanding, selling for $83.40 per share; beta is 1.19.
Preferred stock:		12,400 shares of 5.95 percent preferred stock outstanding, currently selling for $97.60 per share.
Market:		7.2 percent market risk premium and 5 percent risk-free rate.

What is the company'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.)

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

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

WACC _______    %

Answer 1

Cost of Equity

As per Capital Asset Pricing Model [CAPM], The Cost of Equity Capital is computed by using the following equation

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

= 5.00% + [7.20% x 1.19]

= 5.00% + 8.57%

= 13.57%

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 8.20% x ½]	PMT	41
Yield to Maturity [YTM]	1/Y	?
Time to Maturity [21 Years x 2]	N	42
Bond Price [-$1,000 x 103%]	PV	-1,030

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 = 7.90%

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

= 7.90% x (1 – 0.40)

= 7.90% x 0.60

= 4.74%

Cost of Preferred Stock

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

= [($100 x 5.95) / $97.60] x 100

= [$5.95 / $97.60] x 100

= 6.10%

Firm’s Market Value Capital Structure

Capital	Calculation	Market Value Capital Structure Weights
Debt	[$9,167,000 / $28,224,840]	0.3248
Preferred Stock	[$1,210,240 / $28,224,840]	0.0429
Equity	[$17,847,600 / $28,224,840]	0.6323

Market Value of each capital Structure

Market Value of Debt = $9,167,000 [8,900 Bonds x $1,030 per bond]

Market Value of Preferred Stock = $1,210,240 [12,400 shares x $97.60 per share]

Market Value of Equity = $17,847,600 [214,000 shares x $83 per share]

Total Market Value = $28,224, 840

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]

= [4.74% x 0.3248] + [6.10% x 0.0429] + [13.57% x .6323]

= 1.54% + 0.26% + 8.58%

= 10.38%

“Therefore, the Company’s WACC will be 10.38%”