Question

You have gathered the following information for Frosty Ale, Inc., which has a 40 percent marginal tax rate. • 2 million common shares outstanding • 120,000 bonds outstanding • Current yield to maturity is 7% • Estimated market risk premium is 6% • Current common stock price is $25 per share • Current preferred stock price is $30 per share • 90,000 preferred shares outstanding • Estimated beta of stock is 1.2 • 10 year U.S. Treasury yield is 4.8% Annual preferred dividend is $3 Bonds are trading at par • Bonds have $1,000 face value What is the firm's weighted average cost of capital (WACC)? Be sure to very clearly label/identify each input or item and what you are doing to have the opportunity

Answer 1

Stock Beta = 1.20

As per CAPM,

$Expected Return = R_f +\beta(R_{mp})$

R_f = Risk free Return or US treasury Yield = 4.8%

R_m = Market Risk Premium = 6%

Expected return = 4.80% + 1.20(6%)

= 12%

So, Cost of Equity = 12%

- Annual dividend on preferred Stock = $3.00

Current Preferred Share Price= $30

Cost of Preffered Share = Annual dividend/Current Price

= $ 3.00/$30

=10%

- Face Value of Bond = $1000

YTM or Cost of debt = 7%

Constructing the Capital structure of funds to obtain weights for WACC calculations:

Fund	No of Outstanding units	Price	Total Value	Weight of Fund in Capital Structure
Stock	2,000,000.00	25.00	50,000,000.00	0.28952
Bond	120,000.00	1000.00	120,000,000.00	0.69485
Preferred Stock	90,000.00	30.00	2,700,000.00	0.01563
			172,700,000.00	1.00

Calculating WACC based on Weights and cost of funds:

WACC= (Weight of Debt)(Cost of Debt)(1-Tax rate) + (Weight of Common stock)(Cost of Retained earnings) +(Weight of Preferred Stock)(Cost of Preferred Stock)

WACC = (0.69485)(7%)(1-0.40) + (0.28952)(12%) + (0.01563)(10%)

WACC = 2.91837% + 3.47424% + 0.1563%

WACC =6.54891%

So, Weighted Average Cost of capital is 6.55%