Suppose Facebook wants to raise capital to start a new project. The CEO asks you

Question

Suppose Facebook wants to raise capital to start a new project. The CEO asks you to calculate their weighted average cost of capital. He gives you these facts. Their tax rate = 34%.

Facebook has a 20 year, 7.3% coupon semiannual payment non-callable bond with a face value of $1,000 that are available for $1,054.34 New bonds will be privately placed with no flotation cost.

Facebook has preferred stock that sells for $115.00 and pays a dividend of $25.

Their common stock sells for $76.50. The annual dividend is $2.35 and the dividend growth rate is 3.6% a year. The stock has a Beta of .87. The risk free rate is 1.75% and the market risk premium is 7.9%.

Facebook considers their bond-Yield Risk Premium to be 2%.

Facebook currently has 30% of their capital coming from debt, 20% from preferred stock and 50% from common equity, however their target is to have 40% from debt, 15% from preferred stock and 45% from common equity.

Show the cost of debt, the cost pf preferred stock, the average of the cost of common equity using the 3 methods we've discussed. Then show the WACC formula and the final WACC value for Facebook.

Explanation / Answer

Cost of debt: 7.3% semi annual coupon bonds of face value $1000 and maturity 20 years sell for $ 1054.34. We will calculate the YTM, which is essentially the discount rate at which the future cash flows will equal the current market price. There will be 40 periods since it is semi annual coupon payments.

1054.34 = 36.5/(1+r) + 36.5/(1+r)2 + 36.5/(1+r)3 + ...... + (1000+36.5)/(1+r)40

solving for r, we get r = 3.40% which is the semi annual rate. The annualised rate will be (3.40*2) = 6.80%

The post tax cost will be 6.80% * (1-34%) = 4.49%. Hence the net cost of debt (as per the current price which is the relevant marginal cost) = Costdebt = 4.49%

Cost of Preferred Stock (CostPref): Since the maturity date is not mentioned, we assume that these preferred shares are perpetual and their marginal cost = Dividend/Current market price = 25/115 = 21.74%

Cost of Equity (Cequity): We will use the following 3 approaches for calculating the equity cost:

Now we can average the equity cost from the 3 methods and use for WACC calculations: Costequity = (8.62%+6.67%+8.80%)/3 = 8.03%

Current WACC = Wdebt * Costdebt + WPref * CostPref + WEquity * CostEquity; where W is the respective weights.

= 30% * 4.49% + 20% * 21.74% + 50% * 8.03% = 9.71%

Target WACC (when they reach their targeted level) = 40% * 4.49% + 15% * 21.74% + 45% * 8.03% = 8.67%

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