Question

Inzaghi Company recently hired you as a consultant to estimate the company’s WACC. You have obtained the following information. (1) The company has noncallable bonds with $1,000 face value and coupon rate of 10% (paid semi-annually). The bonds mature in 4 years, and have current price of $1,140. (2) The company’s tax rate is 30%. (3) The current price of the company’s stock is $80.00 per share. Dividends are expected to grow at 5% indefinitely and the most recent dividend paid by the company was $2.75 per share. (4) The target capital structure of the company consists of 41.5% debt and the balance is common equity. (5) The company is not planning to issue any new common stock. What is Inzaghi Company’s WACC? ** You must explain your approach in writing in four lines

Answer 1

Answer: (p) x (q) Weighted (p) (q) Source of Weight Cost Сapital Cost [58.5% x 8.61%] 58.5% 8.61% 5.04% Equity [41.5% x 2.10% [5.04%0.87% Debt 41.5% 2.10% 0.87% Weighted Avg. Cost of Capital (WACCC) 5.91% Explanation about WACC: When capital structure consists of 41.5% of debt, there should be 1 -41.5% = 58..5% of equity. Weighted average cost of capital refers to cost of total capitals contributed in the business but after considering weights of each source of capital contributed such as debt capital and equity capital. Debt capital is also called as external capital as it is contributed by external parties such as banks, financial institutions, etc. and interest payable on debt capital is tax deductible expense. Equity capital is also called as internal capital as it is contributed by internal parties such as common shareholders and preferred shareholders but dividends paid to shareholders are not tax deductible expenses as they are just division of firm's profits.

Workings: According to dividend growth model, Cost of equity [Recent dividend x (1+ Growth rate) /Current stock price] Growth rate $2.75 Recent dividend Growth rate 5% Current stock price Cost of equity $80.00 8.61% {[$2.75 x (1+5%) / $80.00] 5%} #of periods left to maturity, NPER 8 [4 years x 2 as there would be two semiannuals in a year] $50 [$1,000 x 10% / 2; as there would be two semiannual payments in year] $1,140 Semiannual coupon Payment, PMT Bond's current selling price, PV Bond's maturity value at the end, F $1,000 [Par value of the bonds] 0 0 if coupons paid at the end of each year; 1 if coupons paid at the beginning of each year 3.01% [Ref: NOTE Semiannual coupon type, TYPE Before-tax cost of debt 30% Tax Rate After-tax cost of debt 2.10% [3.01% x (1-30%)]

NOTE Before-tax cost of debt is calculated using EXCEL FUNCTION RATE(nper,pmt,pv,fv,type) where nper-8; pmt-50; fv=-1000; type-0; Here, pmt & fv are negative as they denote cash inflows; pv is positive as it denotes cash outflow; type-0 as coupon paid at the end of each year only. A B C D G 1 #of periods left to maturity, NPER 2 Semiannual coupon Payment, PMT 3 Bond's current selling price, PV 4 Bond's maturity value at the end, FV 4*2 [4 years x 2 as there would be two semiannuals in a year] -B4*10 % / 2 [$1,000 x 10% / 2; as there would be two semiannual payments in year] $1,140 $1,000 [Par value of the bonds] 5 Semiannual coupon type, TYPE 0 if coupons paid at the end of each year; 1 if coupons paid at the beginning of each year 0 -RATE(B1,-B2,B3,-B4,B5) [Ref: NOTE] Before-tax cost of debt 6 7 Tax Rate 30% 8 After-tax cost of debt B6*(1-B7)