The Saunders Investment Bank has the following financing outstanding. 50,000 bon

Question

The Saunders Investment Bank has the following financing outstanding.

50,000 bonds with a coupon rate of 8 percent and a current price quote of 108.0; the bonds have 20 years to maturity. 220,000 zero coupon bonds with a price quote of 21.0 and 30 years until maturity.

140,000 shares of 6 percent preferred stock with a current price of $77, and a par value of $100.

2,500,000 shares of common stock; the current price is $63, and the beta of the stock is 1.40.

The corporate tax rate is 35 percent, the market risk premium is 6 percent, and the risk-free rate is 3 percent.

The Saunders Investment Bank has the following financing outstanding.

Explanation / Answer

The formula for weighted average cost of capital is:

WACC = Weight of Debt*After Tax Cost of Debt + Weight of Preferred Stock*Cost of Preferred Stock + Weight of Equity*Cost of Equity

To calculate, WACC, we need to calculate the cost of different financial instruments and weight of each type of instrument.

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Step 1 Calculate Cost of 2 Bonds:

Bond 1:

The cost of debt can be calculated with the use of EXCEL/Financial calculator. The function/formula for calculating cost of debt is Rate(Nper,PMT,-PV,FV) where Nper is the period, PMT is the amount of interest payment, PV is the current bond price and FV is the face value of bonds. The bond is treated as a semi-annual bond.

For Bond 1, Nper = 20*2 = 40, PMT = 1000*8%*1/2 = $40, PV = 1000*108% = -$1,080 and FV = $1,000

Cost of Debt with the use of above function:

Cost of Debt = Rate(40,40,-1080,1000)*2 = 7.24% (we multiply by 2 because the bond in treated as a semi-annual bond)

After Tax Cost of Debt = Cost of Debt*(1-Tax Rate) = 7.24*(1-35%) = 4.70%

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Bond 2:

Here, Nper = 30*2 =60, PMT = 1000*0*1/2 = 0, PV = 1000*21% = -$210 and FV = $1,000

Cost of Zero Coupon Bond = Rate(60,0,-210,1000)*2 = 5.27%

After Tax Cost of Zero Coupon Bond = Cost of Zero Coupon Bond *(1-Tax Rate) = 5.27*(1-35%) = 3.43%

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Step 2: Calculate Cost of Preferred Stock:

Cost of Preferred Stock = Annual Dividend/Current Stock Price*100

Annual Dividend = 100*6% = $6

Current Stock Price = $77

Using these values,

Cost of Preferred Stock = 6/77*100 = 7.79%

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Step 3: Calculate Cost of Equity:

The cost of equity will be calculated with the use of CAPM Model. The formula is:

Cost of Equity = Risk Free Rate + Beta*(Market Risk Premium) = 3 + 1.40*(6) = 11.40%

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Step 4: Calculate Weights Based on Market Values:

Market Value of Bond 1 = Number of Bonds*Face Value of bonds*Quoted Price = 50,000*1000*108% = $54,000,000

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Market Value of Zero Coupon Bond = Number of Zero Coupon Bonds*Face Value of Bonds*Quoted Price = 220,000*1000*21% = $46,200,000

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Market Value of Preferred Stock = Number of Shares*Current Share Price = 140,000*77 = $10,780,000

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Market Value of Equity = Number of Shares*Current Price = 2,500,000*63 = $157,500,000

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Total Value of the Firm = Market Value of Debt + Market Value of Preferred Stock + Market Value of Equity = (54,000,000 + 46,200,000 + 10,780,000 + 157,500,000) = $268,480,000

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Weight of Bond 1 = $54,000,000/$268,480,000

Weight of Bond 2 = $46,200,000/$268,480,000

Weight of Preferred Stock = $10,780,000/$268,480,000

Weight of Equity = $157,500,000/$268,480,000

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Step 5: Calculate WACC (Using Formula Mentioned Above):

WACC = 4.70*54,000,000/268,480,000 + 3.43*46,200,000/268,480,000 + 7.79* 10,780,000/268,480,000 + 11.40*157,500,000/$268,480,000 = 8.54%

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