Risk Free Rate: 4.5%, Market Risk Premium 9.6%, Marginal Tax Rate 15% Stock $50

Question

Risk Free Rate: 4.5%, Market Risk Premium 9.6%, Marginal Tax Rate 15%

Stock $50 per share Beta 1.21 2 million shares outstanding Par value $1 Bonds 10,000 outstanding Par value $1000 8% annual coupon (coupons paid semiannually) 22 years to maturity Market price: $1,101.23 Preferred Stock 150,000 shares outstanding Coupon payment of $10 Market price of $120 Par value $100 What is the weighted cost of equity? What is the after-tax weighted cost of debt? What is the weighted cost of preferred stock? What is the WACC?

Explanation / Answer

Weighted Average cost of capital is the total cost of all the capital source taken together in the firm. It the measure which provides the total cost of the funds borrowed by the firm for the purposes of the business.

WACC = Weight of Stock * Cost of Stock or equity + Weight of Preferred Stock * Cost of Preferred Stock + Weight of Debt * Cost of Debt

Now lets calculate the weights first:-

1. Weight of common stock = Value of common stock / Total Value of funds

Total Value of Funds = Value of common stock + Value of preferred stock + Value of Bonds

Value of common stock = $ 50 * 2,000,000 shares = $ 100,000,000

Value of bond = 10,000 shares * $ 1,101.23 = $ 11,012,300

Value of preferred stock = 150,000 shares * $ 120 = 18,000,000

Total Value of funds = $ 129,012,300

Weight of common stock = $ 100 million / $ 129,012,300 = 77.51%

Weight of preferred stock = $ 18 million / $ 129,012,300 = 13.95%

Weight of Bond = 8.54%

Now calculate the cost of each capital

1. Cost of equity = Risk free return + Market risk premium * Beta

= 4.5% + 9.6% * 1.21

= 16.12%

2. Cost of preferred stock = Coupon Payment / Market Price of share = $ 10 / $ 120 = 8.33%

3. Cost of Bond = (Coupon Payment (1-Tax) - Premium Amount / Coupon Numbers) / Market Value of Bond

= [80 (1-0.15) - $ 101.23 / 44] / $ 1,101,.23

= 68 - 2.3 / $ 1,101.23

= 5.97%

Now let us answer the above questions:

a. Weighted cost of equity

Weight of equity = 77.51%

Cost of equity = 16.12%

Weighted Cost of equity = 0.7751 * 16.12% = 12.49%

b. After tax Weighted cost of debt

Weight of Debt = 8.54%

Cost of equity = 5.97%

Weighted Cost of equity = 0.0854 * 5.97% = 0.51%

c. Weighted cost of preferred stock

Weight of preferred stock = 13.95%

Cost of preferred stock = 8.33%

Weighted Cost of equity = 0.1395 * 8.33% = 1.16%

d.WACC

= 12.49% + 0.51% + 1.16% = 14.17%

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