Question

Question 5 (14 marks) The Basket Weavers Company has 100,000 units of semi-annual coupon, 20-year bonds outstanding that are currently selling at par value ($1000). The coupon rate of the bond is 7.47%. The company also has 1 million shares of 10.5 percent preferred stock outstanding and 5 million shares of common stock outstanding. The preferred stock has a par value of $100 and is selling for $60 per share. The common stock has a beta of 1.5 and is selling for $40 per share. The U.S. Treasury bill is yielding 3 percent and the return on the market portfolio is 12 percent. The corporate tax rate is 35 percent. (a) Calculate the cost of equity of the Basket Weavers Company. (2 marks) (b) Calculate the cost of preferred stock of the Basket Weavers Company. (2 marks) (c) Calculate the after-tax cost of debt of the Basket Weavers Company. (2 marks) (d) Calculate the weighted average cost of capital of the Basket Weavers Company. (5 marks) (e) Should the weighted average cost of capital be used as a required return for an investment project which has a much higher risk than the overall risk of the company? Explain briefly. (3 marks)

Answer 1

a]

cost of equity (CAPM) = risk free rate + (beta * (market return - risk free rate))

cost of equity (CAPM) = 16.50%

b]

cost of preferred stock = 17.50%

c]

aftertax cost of debt = YTM of bond * (1 - tax rate)

YTM is calculated using RATE function in Excel with these inputs :

nper = 20*2 (20 years to maturity with 2 semiannual coupon payments each year)

pmt = 1000 * 7.47% / 2 (semiannual coupon payment = face value * annual coupon rate / 2. This is a positive figure as it is an inflow to the bondholder)

pv = -1000 (Current bond price. This is a negative figure as it is an outflow to the buyer of the bond)

fv = 1000 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)

The RATE calculated is the semiannual YTM. To calculate the annual YTM, we multiply by 2.  

aftertax cost of debt = YTM * (1 - tax rate)

aftertax cost of debt  = 4.86%

d]

WACC = (weight of debt * cost of debt) + (weight of preferred stock * cost of preferred stock) + (weight of common stock * cost of common stock)

market value of debt = bonds outstanding * market price per bond

market value of preferred stock = shares outstanding * market price per share

market value of common stock = shares outstanding * market price per share

weight of debt = market value of debt / total market value

weight of preferred stock = market value of preferred stock / total market value

weight of common stock = market value of common stock / total market value

WACC = 13.43%

All the calculations are below :

А с E 1 Units Weight 2 3 Source Debt Preferred Common B Price $1,000 $60 $40 D Total market value 100,000 $ 100,000,000 1,000,000 $ 60,000,000 5,000,000 $ 200,000,000 $ 360,000,000 0.2778 0.1667 0.5556 F After-tax Cost 4.86% 17.50% 16.50% 13.43% 4 Totals WACC 5 6 7 Additional Bond Data 8 Tax rate 9 Coupon rate 10 Face value 11 Maturity 12 Price Additional Preferred Data 35% Dividend 7.47% Price $1,000 20 $1,000 Additional Common Data $10.50 beta $60 risk free rate market return 1.50 3% 12%

B חד с D E Units Price 1000 60 100000 1000000 5000000 Totals Total market value Weight =B2*C2 =D2/$D$5 =B3*C3 =D3/$D$5 =B4*C4 =D4/$D$5 =SUM(D2:04) WACC After-tax Cost =RATE(B11*2,B10*B9/2,-B12,B10)*2*(1-B8) =D8/D9 =F9+(F8* (F10-F9)) =SUMPRODUCT(E2:E4,F2:F4) 40 A 1 Source 2 Debt 3 Preferred 4 Common 5 6 7 Additional Bond Data 8 Tax rate 9 Coupon rate 10 Face value 11 Maturity 12 Price 1.5 Additional Preferred Data 0.35 Dividend 0.0747 Price 1000 10.5 60 Additional Common Data beta risk free rate market return 0.03 0.12 20 1000

e]

No.

For a project with higher risk, the WACC should be adjusted upward by adding a premium to account for the higher risk of the project.