Scenario: ACE Inc. is trying to determine the company’s weighted average cost of
ID: 2472261 • Letter: S
Question
Scenario:
ACE Inc. is trying to determine the company’s weighted average cost of capital (WACC). Use the following information to make this calculation for them.
-ACE’s stock has a current market price of $52.25 a share and the company expects to pay a dividend next year of $3 per share.
-Dividends have been growing at a constant rate of 5% a year and are expected to continue that pattern.
-The company also has a small amount of preferred stock outstanding that currently sells for $107 per share and pays an 8% of par value ($100) dividend.
-ACE also has one bond issue outstanding that has a 7% coupon rate and pays interest annually.
-Those $1,000 par value bonds currently have 9 years remaining to maturity and are selling for $941 each.
-The total market value of the company’s common stock is $45 million, preferred stock $6 million, and debt is $33 million.
-ACE’s marginal tax rate is 15%.
Please answer the following questions and show work.
1. What weights would you use for ACE's debt, common stock, and preferred stock?
2. Calculate ACE's after-tax cost of debt.
3. Calculate ACE's cost of preferred stock.
4. Calculate ACE's cost of common stock.
5. Calculate ACE's WACC.
6. ACE is considering investing in a project and can borrow money at 5%. What discount rate should ACE use and why?
7. How would your answer change if the company did not expect dividends to increase in the future?
8.How would your answer change if the company's bonds paid semi-annual interest payments?
Explanation / Answer
6
ACE is considering investing in a project and can borrow money at 5%. It should use the discount rate at which the net present value is equal to the money borrowed.
7)
IF the company did not expect dividends to increase in the future the cost of equity will decrease and the WACC will also decrease. Below are the calculations:
8)
If bond pays semi annual payment the answer would change as follows.
1 Particulars Market value in millions Weights = Market value / total capital market value of the company’s common stock 45 0.5357 market value of the company’s preferred stock 6 0.0714 market value of the company’s debt 33 0.3929 Total Market value of the company's capital 84 1.0000 2 Bond current price $ 941 Coupan rate 7% Face value $ 1,000 Interest payment 70 Remaining life 9 941 = 70x(PVIFAr, 9) + 1000x( PVIFr , 9) Pretax cost of debt 7.94% After tax cost of debt = 7.94 (1-.15) 6.75 3 Cost of preferred stock (8%*100)/107 7.48% 4 Cost of equity (next year annual dividend / Current stock price ) + Dividend Growth Rate Dividend 3 Current market price 52.25 Dividend growth rate 5% Cost of equity 10.74%Related Questions
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