4. (1pt) Phillips Equipment has 80,000 bonds outstanding that are selling at par

Question

4. (1pt) Phillips Equipment has 80,000 bonds outstanding that are selling at par. Bonds with similar characteristics are yielding 6.75 percent. The company also has 750,000 shares of 7 percent preferred stock and 2.5 million shares of common stock outstanding. The preferred stock sells for $53 a share. The common stock has a beta of 1.34 and sells for $42 a share. The U.S. Treasury bill is yielding 2.8 percent and the return on the market is 11.2 percent. The corporate tax rate is 38 percent. What is the firm's weighted average cost of capital?

this is the correct answer (10.40%)

Explanation / Answer

Value of the different components

Bonds = $1000 * 80,000 = $80,000,000

Preferred Stock = $53 * $750,000 = $39,750,000

Common Stock = $42 * 2,500,000 = $105,000,000

Total of all components = $80,000,000 + $39,750,000 + $105,000,000

= $224,750,000

Cost of capital for each component

Cost of bond = 6.75%

Cost of preferred stock = (7% * $100) / $53 ----------------------------- ($100 is the face value of the preferred stock)

= 13.21%

Cost of common stock = 2.8% + 1.34 * (11.2% - 2.8%)----------------(based on CAPM model)

= 14.06%

Now, firm's average cost of capital = ($80,000,000 / $224,750,000) * 6.75% * (1 - 38%) + ($39,750,000 / $224,750,000) * 13.21% + ($105,000,000 / $224,750,000) * 14.06%

= 10.39%

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