Whatley Inc. has a target capital structure consisting of 35% debt, 10% preferre

Question

Whatley Inc. has a target capital structure consisting of 35% debt, 10% preferred stock, and 55% common equity. The firm has 20-year, 8.8% semiannual coupon bonds that sell for $920.50. Whatley also has preferred stock that pays an 8.4% annual dividend (with a par value of $100) and sells for $75. Finally, Whatley plans to pay an annual dividend of S2 on its common stock that currently sells for $22.50 a share. Whatley's stock is a constant growth stock with a growth rate of 5%. Flotation costs on new common stock are 10%, and the firm's marginal tax rate is 40%. 6. (7 points) a. What is Whatley's after-tax component cost of debt? b. What is Whatley's component cost of preferred stock? c. What is Whatley's component cost of external equity (cost of equity issuing new stock)? d. Assume that Whatley does have to issue new common stock to fund the equity portion of its capital budget, what is their WACC?

Explanation / Answer

Answer a.

Face Value = $1,000
Current Price = $920.50

Annual Coupon Rate = 8.80%
Semiannual Coupon Rate = 4.40%
Semiannual Coupon = 4.40%*$1,000 = $44

Time to Maturity = 20 years
Semiannual Period to Maturity = 40

Let semiannual YTM be i%

$920.50 = $44 * PVIFA(i%, 40) + $1,000 * PVIF(i%, 40)

Using financial calculator:
N = 40
PV = -920.50
PMT = 44
FV = 1000

I = 4.854%

Semiannual YTM = 4.854%
Annual YTM = 2 * 4.854%
Annual YTM = 9.708%

Before-tax Cost of Debt = 9.708%
After-tax Cost of Debt = 9.708% * (1 - 0.40)
After-tax Cost of Debt = 5.82%

Answer b.

Face Value = $100
Current Price = $75
Annual Dividend = 8.40%*$100 = $8.40

Cost of Preferred Stock = Annual Dividend / Current Price
Cost of Preferred Stock = $8.40 / $75
Cost of Preferred Stock = 11.20%

Answer c.

Current Price, P0 = $22.50
Expected Dividend, D1 = $2
Growth Rate, g = 5%
Flotation Cost, F = 10%

Cost of External Equity = D1 / [P0*(1-F)] + g
Cost of External Equity = $2.00 / [$22.50*(1-0.10)] + 0.05
Cost of External Equity = 14.88%

Answer d.

WACC = Weight of Debt*After-tax Cost of Debt + Weight of Preferred Stock*Cost of Preferred Stock + Weight of Common Stock*Cost of External Equity
WACC = 0.35 * 5.82% + 0.10 * 11.20% +0.55 * 14.88%
WACC = 11.34%

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