Question

1. Christmas Trees by Jimmy has 100,000 shares of common stock outstanding at a market

price of $17 a share. The common stock just paid an annual dividend of $1.50 and has a
growth rate of 2.5 percent. There are 10,000 shares of 9% preferred stock outstanding at a
market price of $39 a share. The outstanding bonds mature in 10 years, have a total face
value of $600,000, a face value per bond of $1,000, and a market price of 99% of par, and
a pretax yield to maturity of 7.8 percent. The tax rate is 38 percent. What's the firm's
weighted average cost of capital?

Answer 1

The firm's weighted average cost of capital (WACC) is 9.31%.

The Breakdown

To calculate the weighted average cost of capital (WACC), we need to determine the cost of each component of the company's capital structure and weight them according to their proportion in the capital structure.

Calculating the cost of each component:

1. Cost of common stock:

Dividend per share = $1.50

Growth rate = 2.5%

Market price per share = $17

Using the dividend discount model, we can calculate the cost of common stock as follows:

Cost of common stock = (Dividend per share / Market price per share) + Growth rate

Cost of common stock = ($1.50 / $17) + 2.5% = 11.76%

2. Cost of preferred stock:

Dividend yield = 9%

Market price per share = $39

Using the dividend discount model, we can calculate the cost of preferred stock as follows:

Cost of preferred stock = Dividend yield / Market price per share

Cost of preferred stock = 9% / $39 = 23.08%

3. Cost of debt:

Face value of bonds = $600,000

Face value per bond = $1,000

Market price per bond = 99% of par = $990

Pretax yield to maturity = 7.8%

Using the yield to maturity, we can calculate the after-tax cost of debt as follows:

After-tax cost of debt = Pretax cost of debt x (1 - Tax rate)

After-tax cost of debt = 7.8% x (1 - 38%) = 4.84%

Next, we need to weight each component by its proportion in the capital structure.

Total market value of common stock = 100,000 shares x $17 per share = $1,700,000

Total market value of preferred stock = 10,000 shares x $39 per share = $390,000

Total market value of debt = $600,000 x 99% = $594,000

Total market value of the firm's capital structure = $1,700,000 + $390,000 + $594,000 = $2,684,000

Weight of common stock = $1,700,000 / $2,684,000 = 63.36%

Weight of preferred stock = $390,000 / $2,684,000 = 14.53%

Weight of debt = $594,000 / $2,684,000 = 22.11%

Finally, we can calculate the WACC as follows:

WACC = (Weight of common stock x Cost of common stock) + (Weight of preferred stock x Cost of preferred stock) + (Weight of debt x After-tax cost of debt)

WACC = (63.36% x 11.76%) + (14.53% x 23.08%) + (22.11% x 4.84%)

WACC = 9.31%

Therefore, the firm's weighted average cost of capital (WACC) is 9.31%.