Ardoin Enterprises has to determine its cost of capital using the following information:
The firm has $40,000,000 in corporate bonds currently selling at 97.5. The bonds mature in 9 years and have an annual coupon rate of 6.6% paid semiannually. The firm faces a 34% tax rate and has 1,500,000 shares of preferred stock that pays a dividend of $0.80 per year and currently sells for $9.00 per share.
Common stock selling for $3.50 per share has just paid a dividend of $0.30 and is expected to grow by 4% forever. The firm has a beta of 1.4 and the risk free rate on treasury securities is 2.5%. The average return on the S&P500 is 12.54%.
Calculate the cost of capital for the firm. Ardoin Enterprises has 25 million common shares outstanding.
As per CAPM |
expected return = risk-free rate + beta * (expected return on the market - risk-free rate) |
Expected return% = 2.5 + 1.4 * (12.54 - 2.5) |
Expected return% = 16.56 |
Price = recent dividend* (1 + growth rate )/(cost of equity - growth rate) |
3.5 = 0.3 * (1+0.04) / (Cost of equity - 0.04) |
Cost of equity% = 12.91 |
Avg cost of equity = (16.56+12.91)/2 = 14.74%
MV of equity=Price of equity*number of shares outstanding |
MV of equity=3.5*25000000 |
=87500000 |
MV of Bond=Par value*bonds outstanding*%age of par |
MV of Bond=1000*40000*0.975 |
=39000000 |
MV of firm = MV of Equity + MV of Bond |
=87500000+39000000 |
=126500000 |
Weight of equity = MV of Equity/MV of firm |
Weight of equity = 87500000/126500000 |
W(E)=0.6917 |
Weight of debt = MV of Bond/MV of firm |
Weight of debt = 39000000/126500000 |
W(D)=0.3083 |
Cost of debt |
K = Nx2 |
Bond Price =∑ [(Semi Annual Coupon)/(1 + YTM/2)^k] + Par value/(1 + YTM/2)^Nx2 |
k=1 |
K =9x2 |
975 =∑ [(6.6*1000/200)/(1 + YTM/200)^k] + 1000/(1 + YTM/200)^9x2 |
k=1 |
YTM = 6.9787503947 |
After tax cost of debt = cost of debt*(1-tax rate) |
After tax cost of debt = 6.9787503947*(1-0.34) |
= 4.605975260502 |
WACC=after tax cost of debt*W(D)+cost of equity*W(E) |
WACC=4.61*0.3083+14.74*0.6917 |
WACC =11.62% |
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