Question

Quiz during the class. Calculate the WACC which represents the "hurdle rate" for a typical project with average risk using midpoint of the range of the marginal cost of common equity using retained earnings or new earnings. Data: A 15-year, 12% coupon, semiannual payment non-callable bonds sell for $1,153.72. New bonds will be privately placed with no flotation cost. A 10%, $1,000 par value, annually dividend, perpetual preferred stock sells for $1,111. Both an existing common stock and a new common stock issue, which incurs a flotation cost of 15% of the proceeds, sells for $50. D1 = $4.3995 and g = 5%. b = 1.2; rRF = 7%; RPM = 6%. Bond-Yield Risk Premium = 4%. Target capital structure: 30% debt, 10% preferred, 60% common equity. Tax rate is 40%. HINTS: Use the formula, WACC = wdrd(1 – T) + wprp + wcrs

Answer 1

a.Year Cashflow DF@4% PV DF@10% PV

$ $ $

0 (1,000) 1 (1,000) 1 (1,000)

1-15 72 11.1184 800 7.6061 548

15 1,000 0.5553 555.3 0.2394 239

NPV 355.3 NPV 213

Kd = LR + NPV1/NPV1 + NPV2 x (HR – LR)

Kd = 4 + 355.3/355.3 + 218 x (10 – 4)

Kd = 4 + 355.3/573.3 x 6

Kd = 7.72%

b. Kp = D/Po

Kp = $100/$1,111

Kp = 0.09 = 9%

c. Ke = D1/Po (1 – FC) + g

Ke = $4.3995/$50(1-0.15) + 0.05

Ke = $4.3995/$42.50 + 0.05

Ke = 0.1535 = 15.35%

WACC = Wdrd(1 – T) + Wprp + Were

WACC = 0.3(7.72)(1-0.4) + 0.1(9) + 0.6(15.35)

WACC = 1.39 + 0.9 + 9.15

WACC = 11.44%

Step-by-step explanation:

In this case, we need to calculate cost of debt, cost of preference shares and cost of equity. Cost of debt is calculated based on internal rate of return. Cost of preferred stock is the ratio of dividend paid to the market price. Cost of equity is a function of D1 divided by current market price after floatation cost plus growth rate. WACC is equal to cost of each source multiplied by respective weights.