Question

use the following information to determine the weighted average cost of capial.

Use the following information to determine tha WACC of Borat Films Inc. $10 million par value bond issue outstanding paying an 8% coupon rate, with 9% YTM and 10 years remaining until maturity $3 million book value preferred stock out an ding at a book value of $15 per share, paying a $2 annual dividend and selling at a market value of 25 per share $20 million market value of common stc tanding with a beta of .8 4% annual T-bill return 10% annual S&P 500 return 35% tax rate

Answer 1

The before tax cost of debt is bond’s yield to maturity (YTM) which is 9%

As the tax rate is 35%

Therefore after tax cost of debt = 9% * (1- 35%)

= 5.85%

Cost of preferred stock rp = dividend paid / current market price of preferred stock

Where,

Annual Dividend = $2

Current market price of preferred stock = $25

Therefore,

Cost of preferred stock rp = $ 2/ $25 =0.08 or 8.00%

Cost of common equity or required rate of return, we can calculate with the following formula

Required rate of return of stock, re = risk-free rate + beta * Market Return – risk free rate)

Where,

Risk-free rate = 4%

Beta of stock = 0.8

Market return (S& P500) = 10%

Therefore

Cost of common equity = 4% + 0.80 * (10% -4%

= 8.8%

Required rate of return or Cost of common equity is 8.8%

Formula for the calculation of weighted average cost of capital (WACC) is

WACC = (E/ E+D+P) * re + (D/ E+D+P) * rd + (P/ E+D+P) * rp ……………………………. (1)

Where, re is the cost of equity = 8.8%

And rd is the after tax cost of debt = 5.85%

And rp is the cost of preferred stock = 8.00%

E is the value of common equity = $20,000,000

D is the value of debt = Value of coupon paying bond = Market value (price)

The Face value or par value of debt is M= $10,000,000

Therefore price P0 =?

Coupon semiannual C = 10,000,000*8% = $800,000

Time n = 10

And i is YTM=9%

Formula for calculation of bond price is

Bond price P0 = C* [1- 1/ (1+i) ^n] /i + M / (1+i) ^n

= $800,000 * [1 – 1 / (1+9%) ^10] /9% + 10,000,000 / (1+9%) ^10

= $9,358,234.23

P is the value of preferred stock = total book value * market value per share/ book value per share

= 3,000,000 *$25/$15

= $5,000,000

Therefore

The total value of Company = E +D + P = $20,000,000 + $9,358,234.23 + $5,000,000 = $34,358,234.23

Now put the values in equation (1) to calculate Company’s WACC

WACC = ($20,000,000/$34,358,234.23) * 8.8% + ($9,358,234.23 /$34,358,234.23) 5.85% + ($5,000,000 / $34,358,234.23) * 8.00%

WACC =5.12%+ 1.59%+ 1.16%

= 7.88%

Therefore the WACC for the company is 7.88%