Question

Question 2 (25 marks) The extract of the capital structure on the Statement of Financial Position of Nelson Inc. for the year ended 2018 is shown as below: Statement of Financial Position for the year ended 31 December 2018 Total (S) Bonds (zero coupon, $1,000 par, 5-year maturity) 3,000,000 Preferred stock ($100 par, 6% dividend) 900,000 Common stock ($10 par) 980,000 4,880,000 Market prices per bond/share are $710 for bonds, $96 for preferred stock, and $35 for common stock, respectively. There will be sufficient internal common equity funding (i.e. retained earnings) available such that the firm does not plan to issue new common stocks. Assume the cost of internal equity is the same as issuing new common stock without consideration of the associated floatation costs. Dividends just paid for common stock were $2.50 last year and are projected to have an annual growth rate of 6%. The firm is in a 34% tax bracket. What is the weighted average cost of capital (WACC) of the company? End of Assignment

Answer 1

Answer:

First we calculate cost of each component:

Cost of debt:

Zero coupon bond:

Par value = $1,000

Price = $710

Time to maturity = 5 Years

Before tax cost of debt = RATE (nper, pmt, pv,fv, type) = RATE (5, 0, -710, 1000, 0) =7.09%

Cost of preferred stock:

Cost of preferred stock = Annual preference dividend / Price = 100 * 6% / 96 = 6.25%

Cost of common stock:

Cost of common stock = (Dividend next year / Price) + Growth rate = (2.50 * (1 +6%) /35) + 6% = 13.57%

Market values of each component:

Common stock = 980000 / 10 * 35 = $3,430,000

Preferred stock = 900000/100 * 96 = $864,000

Debt = 3000000 / 1000 * 710 = $2,130,000

Total market value = 3430000 + 864000 +2130000 = $6,424,000

WACC:

WACC = Cost of common stock * weight of common stock + Cost of preferred stock * weight of preferred stock + Before tax cost of debt * (1 - Tax rate) * weight of debt

= 13.57% * 3430000/6424000 + 6.25% * 864000 / 6424000 + 7.09% * (1 - 34%) * 2130000 / 6424000

= 9.64%

WACC of the company = 9.64%