Question

The market value of Fords' equity, preferred stock and debt are 57 billion, $5 billion and $11 billion respectively. Ford has a beta of 1.5, the market risk premium is 8% and the risk-free rate of interest is 3%. Ford's preferred stock pays a dividend of S4 each year and trades at a price of $25 per share. Ford's debt trades with a yield to maturity of 10%. What is Ford's weighted average cost of capital if its tax rate is 35%? O A 10.04% OB. 9.48% O C. 11.15% OD 10.59%

Answer 1

The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) which is calculated using the formula below:

Ke=Rf+b[E(Rm)-Rf]

where:

Rf=risk-free rate of return

Rm=expected rate of return on the market.

b= stock’s beta

Ke= 3% + 1.5*8%

= 3% + 12%

= 15%

The cost of preferred stock is calculated using the below formula:

Kps=Dps/P

where:

Kps= Cost of preferred stock

Dps= preferred dividend

P= Market price of preferred stock

Kps= $4/ $25

= 0.16*100

= 16%

Total value of the firm= $7 million + $5 million + $11 million

= $23 million

Weight of equity= $7 million/ $23 million

= 0.3043

Weight of preference stock= $5 million/ $23 million

= 0.2174

Weight of debt = $11 million/ $23 million

= 0.4783

The weighted average cost of capital is calculated using the below formula:

WACC=Wd*Kd(1-t)+Wps*Kps+We*Ke

where:

Wd= Percentage of debt in the capital structure.

Kd= The before tax cost of debt

Wps= Percentage of preferred stock in the capital structure

Kps=Cost of preferred stock

We=Percentage of equity in the capital structure

Ke= The cost of common equity.

T= Tax rate

WACC= 0.4783*10%*(1 - 0.35) + 0.2174*16% + 0.3043*15%

= 0.4783*6.50% + 0.2174*16% + 0.3043*15%

= 3.1090% + 3.4783% + 4.5645%

= 11.1518% 11.15%.

Hence, the answer is option c.

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