Question

The Rolling Dough Dessert Company currently has debt which consists of 8 percent coupon bonds (semi-annual coupon payments) which have a maturity of 14 years and are currently priced at $1,154 per bond. There are 12,000 of these bonds outstanding. The firm also has an issue of 1 million preferred shares outstanding with a market price of $14.00 per share. The preferred shares pay an annual dividend of $0.85. RDDC also has 1.5 million shares of common stock outstanding with a price of $19.00 per share. The firm’s beta is 1.3 and the current risk-free rate is 4%. If the expected return on the market is 9% and RDDC is subject to a 40 percent marginal tax rate, then what is the firm's weighted average cost of capital?

Please show all steps with the formula.

im not sure what to do with all the percentages and when.

Answer 1

Firm’s Market Value Capital Structure

Capitals	Number of Bonds/Shares	Market Value per Bond/Share	Market Value [ Number of Bonds or Shares / Market Value per Bond or Share]	Weight to total market value Market value / Total market value]
Bond	12,000	1,154.00	1,38,48,000	0.2458
Preferred Stock	10,00,000	14.00	1,40,00,000	0.2484
Common Stock	15,00,000	19.00	2,85,00,000	0.5058
TOTAL			5,63,48,000	1.0000

After-Tax Cost of Debt

The After-tax Cost of Debt is the after-tax Yield to maturity of the Bond

The Yield to maturity of (YTM) of the Bond is calculated using financial calculator as follows (Normally, the YTM is calculated either using EXCEL Functions or by using Financial Calculator)

Variables	Financial Calculator Keys	Figure
Par Value/Face Value of the Bond [$1,000]	FV	1,000
Coupon Amount [$1,000 x 8.00% x ½]	PMT	40
Market Interest Rate or Yield to maturity on the Bond	1/Y	?
Maturity Period/Time to Maturity [14 Years x 2]	N	28
Bond Price/Current Market Price of the Bond [-$1,154]	PV	-1,154

We need to set the above figures into the financial calculator to find out the Yield to Maturity of the Bond. After entering the above keys in the financial calculator, we get the semi-annual yield to maturity (1/Y) on the bond = 3.165%.

The semi-annual Yield to maturity = 3.165%.

Therefore, the annual Yield to Maturity = 6.33% [3.165% x 2]

After Tax Cost of Debt = Bond’s YTM x [ 1 – Tax Rate]

= 6.33% x (1 – 0.40)

= 6.33% x 0.60

= 3.80%

Cost of Preferred Stock

Cost of Preferred Stock = [Preferred Dividend / Selling Price] x 100

= [$0.85 / $14.00] x 100

= 6.07%

Cost of Equity

As per Capital Asset Pricing Model [CAPM], the cost of equity is calculated by using the following equation

Cost of equity = Risk-free Rate + Beta(Market Rate of Return – Risk-free Rate)

= 4.00% + 1.30[9.00% - 4.00%]

= 4.00% + [1.30 x 5.00%]

= 4.00% + 6.50%

= 10.50%

Weighted Average Cost of Capital (WACC)

Therefore, the Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of Preferred stock x Weight of preferred stock] + [Cost of equity x Weight of Equity]

= [3.80% x 0.2458] + [6.07% x 0.2484] + [10.50% x 0.5058]

= 0.93% + 1.51% + 5.31%

= 7.75%

“Hence, the firm's weighted average cost of capital will be 7.75%”