Question

Your task is to find the cost of capital (WACC)  for a company . The company has two sources of capital available. The marginal tax rate for the company is 35%.

Debt 1 : 400 discount (e.g zero coupon) bonds with 10 000$ par value and 5 years to maturity. Bonds currently offer 5% yield to bondholders.

Debt 2: The company has also recently obtained financing from the bank. The current loan balance is 4 000 000$ and the annual interest charged by bank is 2.4%.

Common stock : 150 000 shares outstanding with the accounting book value of 40$ but the company was recently able to issue new stock with price of 50$ . The company paid recently out 3.2$ as a dividends and expert dividends to grow by 3% annualy within foreseen future.

1. Estimate the capital structure weights for each source and cost of each source when necessary
2. Find the cost of capital (WACC) for the company

Answer 1

Source Market Total # of units value market outstanding per unit value 150,000 50$ 7,500,000$ [150000 x 50$] 400 7,835.26$ 3,134,105$ (400 x 7835.26$] - 4,000,000$ [Given] Firm's market value 14,634,105$ Capital Structure Weights 0.5125 0.2142 0.2733 Common Debt-1 Debt-2 [7500000$ / 14634105$] [3134105$ / 14634105$] [4000000$ / 14634105$] Workings: Market value of a zero coupon bond = Maturity value / (1 + Interest rate)me 10,000$ 5% Maturity value Interest rate Number of years to maturity Market value of a zero coupon bond 5 7,835.26$ (10000$ / (1+5%)^5]

b) Source Weighted Cost Common Debt-1 Debt-2 Capital Cost Structure (Ref: NOTE) Weights 0.5125 9.59% 0.2142 3.25% 0.2733 1.56% Company's WACC 4.92% 0.70% 0.43% 6.04% (0.5125 x 9.59%] (0.2142 x 3.25%] [0.2733 x 1.56%] [4.92% +0.7% +0.43%] NOTE: Using Dividend Growth Model, Cost of Common Equity = [Current Dividend x (1 + Growth Rate) / Stock Price] + Growth Rate 3.2$ 3% Current Dividend Growth Rate Stock Price Cost of Common Equity 50$ 9.59% [(3.2$ x (1+3%) / 50$) + 3%] After-tax cost of debt = Before-tax cost of debt x (1 - Tax rate) Debt-1 Before-tax Cost of debt Tax Rate After-tax Cost of debt 5% 35% 3.25% Debt-2 2.4% 35% 1.56% [Debt-1 = 5% x (1-35%) = 3.25%; Debt-2 = 2.4% x (1-35%) = 1.56%]