Question

Please first estimate the cost of each component of capital. Then, figure out the current capital structure according to the market value of debt and of equity. Finally, calculate the WACC. Cost of Debt, ra: Allied has outstanding 20-year noncallable bonds with a face value of $1,000, an 8% annual coupon (annual payment), and a market price of $908.71. If Allied is planning to issue new debt, what would be a reasonable estimate of the interest rate on the new debt? If Allied's marginal tax rate is 40%, what is its after-tax cost of debt? Before-tax cost of debt: Timeline: (you can skip the timeline.) PMT: FV: I/Y: PV: MODE: Answer: After-tax cost of debt: Answer: Cost of Preferred Stock, rp: Allied's preferred stock currently trades at $50 per share and pays a $5 annual dividend per share. Ignoring flotation costs, what is Allied's cost of preferred stock? Answer:

Answer 1

1). Cost of debt: PV = -908.71; PMT = coupon rate*par value = 8%*1,000 = 80; FV = 1,000; N = 20; Mode = 0, solve for RATE.

YTM (or cost of debt rd) = 9.00%

After-tax cost of debt = rd*(1-Tax rate) = 9%*(1-40%) = 5.40%

2). Cost of preferred stock (rps) = annual dividend/current price per share = 5/50 = 10%

3). Cost of retained earnings (rs):

a). Using CAPM: rs = risk-free rate + stock beta*(market return - risk-free rate) = 6% + 1.6*(11%-6%) = 14%

b). Bond yield plus risk-premium apporach: rs = bond yield+ risk premium = 9% + 4% = 13%

c). Using DCF approach: rs = growth rate + (next dividend/current price) = 6% + (2/25) = 14%

Range of estimations is from 13% to 14%.

mid-point of the range is 13.5%. This will be taken to be the cost of retained earnings.

4). Cost of new common stock (re):

rs using DCF approach = D1/P*(1-F) + g where D1 = next dividend; P = current share price; F = flotation cost; g = growth rate

rs = 2/(25*(1-14%) + 6% = 15.30%

Flotation cost adjustment = cost of new common stock using DCF - cost of retained earnings using DCF = 15.30% - 14% = 1.30%

Cost of external equity re = rs + flotation cost adjustment = 13.5% + 1.30% = 14.80%

5). As per the notes, debt is trading at par so market value of debt will be equal to its book value which is 750 million.

Market value of equity = price per share*number of shares = 23.06*50 = 1,153 million.

Total capital = debt + equity = 750 + 1,153 = 1,903 million

Weight of debt = debt/total capital = 750/1,903 = 39.41%

Weight of equity = equity/total capital = 1,153/1,903 = 60.59%

6). Target capital structure: wd = 45%; wps = 2%; we = 53%

6-1). WACC if equity is raised from retained earnings = (wd*rd*(1-T)) + (wps*rps) + (we*rs)

= (45%*5.40%) + (2%*10%) + (53%*13.50%) = 9.79%

6-2). WACC if equity is raised from retained earnings = (wd*rd*(1-T)) + (wps*rps) + (we*re)

= (45%*5.40%) + (2%*10%) + (53%*14.80%) = 10.48%