Question

3- Your company is estimating its WACC. Its target capital structure is 30 percent debt, 10 percent preferred stock, and 60 percent common equity. Its bonds have an 8 percent coupon, paid quarterly, a current maturity of 15 years, and sell for $895. The firm could sell, at par, $100 preferred stock which pays $10 annual dividend, but flotation costs of 5 incurred if the company will ssue new preferred stocks. This company's beta is 1.3, the risk-free rate is 8 percent, and the market risk premium is 7 percent. This is a constant-growth firm and it just paid a dividend of $1.00, sells for $30.00 per share, and has a growth rate of 6 percent. The firm's policy is to use a risk premium of 5 percentage points when using the bond-yield-plus- risk-premium method to find cost of equity. The company will incur 7% floatation cost if issuing new common stocks. The firm's marginal tax rate is 40 percent. percent would be 1. What is the component cost of debr? 2. What is the cost of new preferred stock? 3. What is the cost of common stock using the CAPM approuch? 4. What is the cost of common stock using the DCF approach 5/ What is cost of common stock using the bond-yield-plus-risk-premium approach? 6. What is current WACC (use CAPM)? What is the WACC if the company will issue new preferred stocks and new common stocks?

Answer 1

1. Component cost of debt can be calculated by calculating the yield to maturity.

Time to maturity - 15 years

Redemption value- $1,000

Coupon rate - 8% quarterly

Coupon amount = (8%*1000)/4 = $ 20

Price of the bond = $895

There are two ways to calculate the yield to maturity i.e using a spreadsheet and using the equation

a. Using spreadsheet

Use the following formula to calculate yield to maturity -

YIELD(settlement, maturity, rate, pr, redemption, frequency,[basis])

settlement date	01-01-2000	(assumed)
maturity date	01-01-2015	(assumed)
coupon rate	8%	quarterly
price	895
coupon payment	$20
Redemption	$1000
The frequency of coupon payment	4
Basis	leave it blank	basis means the convention used for time to maturity.

Using these parameters Yield to maturity i. cost of debt = 2.2346% quarterly = 8.9385% p.a

b. another method is to calculate using the formula for the price of a bond

Price= PV of par value + PV of coupon payments

PV = Coupon₁ / (1+ YTM)¹ + Coupon₂ / (1+ YTM)² +.........+Coupon₅₉/ (1+ YTM)¹⁴+

(Coupon₆₀+ FV) / (1+ YTM)⁶⁰

$ 895 = Coupon₁ / (1+ YTM)¹ + Coupon₂ / (1+ YTM)² +.........+Coupon₅₉/ (1+ YTM)⁵⁹+

(Coupon₆₀+ FV) / (1+ YTM)⁶⁰

$ 895 =20/ (1+ YTM)¹ + 20 / (1+ YTM)² +.........+20/ (1+ YTM)⁵⁹+

(20 + 1000) / (1+ YTM)⁶⁰

Using this equation YTM = 2.2345% quarterly

Also after tax cost of debt component = 2.2345% *( 1 - 40%) = 1.3407% quarterly or 5.3628% p.a

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2. Costy of preferred stock can be calculated using the formula

r_ps = D_ps/ (P_ps × (1 – F))

ps represents preferred stock

P_ps- Price per share

F- floatation cost incurred to issue preferred stock

r_ps = $10/ ($100*(1- 5%))

= 10/(100*0.95)

cost of preferred stock = 10/95 = 10.526%

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3. Cost of common stock using CAPM model

r = R_f + $\beta$ * Market risk premium

r = 8% + 1.3 * 7% = 8% + 9.1% = 17.1%

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4. Cost of common stock using DCF approach

r = (D₁ / P) + g

D_1- dividend in the next period

P- Price of common stock

g- Earnings growth rate

r= (1*(1+6%) / 30 ) + 6%

= (1.06 / 30) +6%

= 3.533% + 6%

cost of common stock using dcf approach = 9.533%