Question

Calculating the WACC. In Problem 12, suppose the most recent dividend was $3.85 and the dividend growth rate is 5 percent. Assume that the overall cost of debt is the weighted average of that implied by the two outstanding debt issues. Both bonds make semiannual payments. The tax rate is 35 percent. What is the company’s WACC?

Answer 1

Weighted average cost of capital (WACC) is the overall cost of capital of the firm and it is the minimum that a company needs to earn. Here total capital means equity and debt (V). Cost of equity means cost incurred by the company to raise its equity share capital. Pretax cost of debt means cost incurred by the company to raise debt capital like debentures, bonds before deducting tax expenses.

Dividend growth model should be used to calculate the cost of equity as dividend and dividend growth both are known.

Calculate WACC by using the following formula:

Here,

is weight of equity in target capital,

is weight of debt in target capital,

is cost of equity,

is cost of debt,

is tax rate.

B Incorporation has 3.9 million shares outstanding and current share price is $11. The company has already issued bonds and there are outstanding during the year. The first bond has a face value $65 million and pays semi-annual coupon of 6.3% and current market price is 98% of book value. The first bond has a face value $50 million and pays semi-annual coupon of 5.8% and current market price is 97% of book value. Current dividend per share of the company is $3.85, growth rate is 5% and current price of the stock is $84.

Calculate cost of equity using dividend growth model as follows:

Therefore, the cost of equity is .

The cost of each debt needs to be calculated which is equal to their yield to maturity.

Calculate cost of first debt as follows:

With 20 years of time to maturity, current price of 98% of face value and coupon rate of 6.3% annually with semiannual payments, and assuming face value of $1000, the yield to maturity of the debt can be calculated as follows:

First semiannual coupon rate needs to be calculated as follows:

To calculate the yield to maturity, excel RATE (NPER, PMT, PV, FV, TYPE) formula should be used with following parameters:

Above parameters should be used in RATE function of excel to calculate the Yield to maturity as follows:

Therefore, the pretax cost of first debt is.

Calculate cost of second debt as follows:

With 12 years of time to maturity, current price of 97% of face value and coupon rate of 5.8% annually with semiannual payments, and assuming face value of $1000, the yield to maturity of the debt can be calculated as follows:

First semiannual coupon rate needs to be calculated as follows:

To calculate the yield to maturity, excel RATE (NPER, PMT, PV, FV, TYPE) formula should be used with following parameters:

Above parameters should be used in RATE function of excel to calculate the Yield to maturity as follows:

Therefore, the pretax cost of debt of second debt is.

Now market value of first and second debt can be calculated as follows:

Calculate WACC as follows:

Therefore, the WACC for the firm based on market value of debt and equity is .