Question

You are given the following information concerning Parrothead Enterprises:

Debt: 9,300 6.5% coupon bonds outstanding, with 22 years to maturity and a quoted price of 104.75. These bonds have a par value of $1,000 and pay interest semi-annually.
Common stock: 240,000 shares of common stock selling for $64.80 per share. The stock has a beta of .93 and will pay a dividend of $3.00 next year. The dividend is expected to grow by 5.3 percent per year indefinitely.
Preferred stock: 8,300 shares of 4.65 percent preferred stock selling at $94.30 per share.
Market: 11.7% expected return, a risk-free rate of 3.75%, and a 23% tax rate.
Calculate the company's WACC.

Answer 1

To calculate the WACC, you need to consider the weight and cost of each source of capital (debt, common stock, and preferred stock). For the debt component, calculate the cost of debt using the coupon rate and yield to maturity. For the common stock component, use the dividend discount model to estimate the cost of equity. For the preferred stock component, calculate the cost of preferred stock using the dividend and price of the stock. Then, multiply each component by its weight and sum them up to get the WACC.

Step-by-step explanation:

To calculate the weighted average cost of capital (WACC), you need to consider the weight of each source of capital and its respective cost. In this case, you have debt, common stock, and preferred stock. The weight of each source is calculated by dividing its market value by the total market value of all sources of capital.

For the debt component, you need to calculate the cost of debt. The coupon rate of 6.5% and the quoted price of 104.75 can be used to estimate the yield to maturity. The coupon payment is $65 ($1,000 x 6.5%) and it is made semi-annually, so the annual payment is $130. Using the yield to maturity formula, you can calculate the present value of the debt payments.

For the common stock component, you need to calculate the cost of equity. The dividend is expected to grow by 5.3% per year, so you can use the dividend discount model (DDM) to estimate the cost of equity. The dividend next year is $3.00, and the growth rate is 5.3%. Plug these values into the DDM formula to get the present value of the equity.

For the preferred stock component, you need to calculate the cost of preferred stock. The dividend is 4.65% of the par value, which is $46.50. The price of the preferred stock is $94.30. Calculate the present value of the preferred stock using these values.

Once you have the present value of each component, multiply it by its respective weight and sum them up to get the WACC. The formula is: WACC = (Weight of debt * Cost of debt) + (Weight of equity * Cost of equity) + (Weight of preferred stock * Cost of preferred stock).

Answer 2

WACC is 8.19%

Step-by-step explanation:

WACC (Weighted Average Cost of Capital is determined by multiplying capital source cost of both equity and debt by their relevant weight and then summing the results to identify the value using the formulae given below:

WACC = (E/V x Re) + [D/V x Rd x (1 - Tc)]

where:

E = Market Value of the firm's equity

D = Market Value of the firm's debt

V = E + D

Re = Cost of Equity

Rd = Cost of Debt

Tc = Tax Rate

In the given question, we will first determine the cost of equity. As shown below:

Cost of Equity = Average of CAPM and Dividend Capitalisation Model

CAPM = Risk free rate of return + Beta x (market rate of return - risk free rate of return)

CAPM = 3.75 + 0.93 x (11.7 - 3.75)

CAPM = 11.14%

Dividend Capitalisation Model = Expected dividend net year / Current Price + Growth Rate

Dividend Capitalisation Model = 3 / 64.8 * 100 + 5.3

Dividend Capitalisation Model = 9.93%

Cost of Equity = 9.93 + 11.14 = 10.54%

Next is the cost of debt which would be calculated using YTM (Yield to maturity)

where:

Par Value = 1047.5

Face Value = 1000

Coupon rate = 6.5

Years to maturity = 22 years

Coupon Payment Frequency is semi annually.

The Cost of debt = 6.1%

After Tax it would be 4.7% [6.1% * (1 - 23%)]

Next, we will determine the rate of preferred stock before calculating the WACC.

Rate of preferred stock = Annual dividend / Current Price * 100

Rate of preferred stock = 4.65 / 94.3 * 100

Rate of preferred stock = 4.93%

Finally, we will calculate the Market Value (MV) of equity, debt and preferred stock. As shown below:

MV Equity = 240,000 x 64.8 = 15,552,000

MV Debt = 1047.5 x 9300 = 9,741,750

MV preferred stock = 8,300 x 94.3 = 782,690

Total = 26,076,440

WACC = (15,552,000 / 26,076,440 * 10.54%) + (9,741,750 / 26,076,440 * 4.7%) + (782,690 / 26,076,440 * 4.93%)

WACC = 6.28% + 1.76% + 0.15%

WACC = 8.19%