Question

Balance Sheet Data

                Long-Term Debt               80,000,000

                Preferred Stock                20,000,000

                Common Equity                20,000,000

Number of shares of Common                 1,500,000                             Price per share Common              $42

Number of shares of Preferred                     150,000                             Price per share Preferred             $108

Number of 8% Coupon 25-year Bonds          40,000                            Price of 8% 25-year Bonds            $1075

Number of 6% Coupon 15-year Bonds          40,200                            Price of 6% 15-year Bonds            $920

Forecasted Dividend on Common (D₁)             $3.25                            Dividend Rate on Preferred         9.5%

Par Value of Preferred                                            $100                            Current 10-Year Treasury Yld.     4.3%

Standard Deviation of Stock                                     40%                          Correlation Stock vs. Market       0.50

Standard Deviation of Market                                 15%                          Market Risk Premium                     4.8%

Risk Premium of our Stock over our 15-yr Bonds          3.8%           Forecasted Constant Growth      2.9%

Tax Rate                                                                           25%                          Flotation costs on Bonds               1.2%

Flotation costs on Preferred                                    2.2%

1. Calculate the appropriate weights to use for the financing sources. (Hint: Assume that the firm feels their current mix of long-term debt is good and would like to raise capital with the same mix of maturities)
2. Calculate the after-tax cost of debt (hint: You can account for the two bonds by taking a weighted average of their cost or by keeping them separate and putting both into the WACC formula at their individual weights). Note that there are flotation costs of 1.2% on bonds.
3. Calculate the cost of preferred. Note that there are flotation costs of 2.2% on preferred stock.
4. Calculate the cost of common (Hint: Use all three methods and take an average). Note that all common equity will come from internally generated equity (retained earnings) which means no new shares will be issued and no flotation costs incurred.
5. Calculate the WACC
6. Why are firms likely to prefer internally generated equity to issuing new shares of common? Identify and briefly explain two reasons.
7. If my firm had two separate divisions – one relatively low risk and one relatively high risk, how might I apply the WACC to each division?

Answer 1

A). Weights are calculated as per current prices and number of securities issued.

	(Price*number of securities)			Weight = Security value/Total value
8% 25-year Bonds	4,30,00,000	Debt	7,99,84,000	50.25%
6% 15-year Bond	3,69,84,000
Preferred stock	1,62,00,000	Preferred stock	1,62,00,000	10.18%
Common equity	6,30,00,000	Common equity	6,30,00,000	39.58%
		Total	15,91,84,000

B). Cost of debt (YTM) for 8% 25-year bond: FV (or par value) = 1,000; PV (price, net of flotation cost) = 1,075*(1-1.20%) = 1,062.10; PMT (or semi-annual coupon payment) = (coupon rate/2)*par value = (8%/2)*1,000 = 40; N (or number of payments) = 25*2 = 50; CPT RATE.

Rate (or semi-annual YTM) = 3.72%

Annual YTM = 3.72%*2 = 7.45%

Cost of debt (YTM) for 6% 15-year bond: FV (or par value) = 1,000; PV (price, net of flotation cost) = 920*(1-1.20%) = 908.96; PMT (or semi-annual coupon payment) = (coupon rate/2)*par value = (6%/2)*1,000 = 30; N (or number of payments) = 15*2 = 30; CPT RATE.

Rate (or semi-annual YTM) = 3.49%

Annual YTM = 3.49%*2 = 6.99%

	(Price*number of securities)	Weight	After-Tax YTM [(1-Tax rate)*YTM]	Weighted YTM
8% 25-year Bonds	4,30,00,000	53.76%	5.59%	3.00%
6% 15-year Bond	3,69,84,000	46.24%	5.24%	2.42%
	7,99,84,000		After-tax cost of debt	5.43%

Note: It is not mentioned whether the bonds pay annual or semi-annual coupons. It is assumed that they are semi-annual.

C). Cost of preferred debt = annual dividend/preferred share price*(1-flotation cost)

= (dividend rate*par value)/(preferred share price*(1-flotation cost))

= (9.50%*1,000)/(108*(1-2.20%)) = 8.99%

D). Average cost of equity = 8.88%

Formula
(Correlation*stock standard deviation(market standard deviation)/(stock standard deviation^2)	Beta	0.188
risk-free rate + (beta*market risk premium)	CAPM	5.20%
(Forecasted dividend/share price) + forecasted constant growth	DDM	10.64%
YTM of 15-year bond + risk premium of stock over 15-year bond	Bond yield + risk premium	10.79%
	Average	8.88%

Note: Please check the numbers you have provided for CAPM calculation, for any typos. Cost of equity calculated using CAPM is low.

E). WACC = Sum of weighted costs = 7.16%

	Weight	Cost
Debt	50.25%	5.43%
Preferred stock	10.18%	8.99%
Common equity	39.58%	8.88%
Total	WACC	7.16%

F). Internally generated equity (or retained equity) is preferred over new shares of common because the cost of retained earnings is less than the cost of new equity due to flotation cost. Also, the additional effort involved in raising new equity such as legalities, etc. are not present with using retained earnings.

G). Division-wise projects should be evaluated using company WACC only. If this is not done, then over a period of time, the company may end up accepting riskier projects and rejected less risky ones, thereby, raising the overall risk of the company which, in turn, will increase WACC.