Question

Preston Corp. is estimating its WACC. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sells for $1,100. The firm could sell, at par, $100 preferred stock which pays a 5.52 percent annual dividend, but flotation costs of 5 percent would be incurred. Preston's beta is 1.2, the risk-free rate is 3 percent, and the market risk premium is 5 percent. The firm's marginal tax rate is 40 percent. What is Preston's WACC

Answer 1

Follows are the solution to this question:

Step-by-step explanation:

`\text{Equity expense = free risk rate+beta} * \text{market risk premium}`

`=3 \% + 1.2 * 5 \% \\\\= 0.03 + 1.2 * 0.05 \\\\= 0.03 +0.06 \\\\= 0.09\\\\=9 \%`

`\text{Preferred inventory cost} = \frac{\text{annual dividend}}{( price - floation \ rate)}`

`= ((100 * 5.46 \%))/((100-100 * 5 \%))\\\\=5.75 \%`

`\text{Excel feature = RATE(nper, PMT, PV, FV)}`

`=(RATE( (20 * 2,1000 * 12 \%)/(2,-1100,1000))) * 2 \\\\=10.77 \%`

`\text{Debt expense after tax}= 10.77 \% * (1-40 \%)`

WACC from Preston = Capital weight
`*` Capital equity costs+cost of common stock
`*` cost of common shares
`*` debt cost
`*` (1-tax rate)

`=60 \% * 9 \%+20 \% * 5.75 \%+20 \% * 6.46 \% \\\\=7.84 \%`