A company\'s Balance Sheet (in millions) Assets Current Net Fixed Liabilities &

Question

A company's Balance Sheet (in millions) Assets Current Net Fixed Liabilities & Equity $120 $180 Bonds ($1000 Par) Preferred stocks ($100 Par) 50 Common Stock ($1 par 20 Total 130 Total $200 $200 The company's bonds have 9 years to mature, pay 10% coupon rate semi-annually and comparable bonds YTMis 1196. The company's applicable tax rate is 40% The market price of common stock is $12.50 per share The common stock dividend has grown at a steady rate from $0.68 in December 2000 to $1.48 in December 2010. The same growth rate is expected to continue for long time in the future The floatation cost for new common stocks is 15%. The market value of the preferred stock is $75 and it pays quarterly dividend of $1.75 The floatation cost on issuing new preferred stock is 7% Next year is 2011 What is the WACC of the company using the book weights of capital structure (Assuming the company will issue new preferred and common stocks)?

Explanation / Answer

COMPONENT COST OF CAPITAL: Cost of debt = YTM*(1-tax rate) = 11*(1-40%) = 6.60% Cost of new preferred stock = Dividend/(Price-Flotation cost) = 1.75/(75-75*7%) = 2.51% Cost of common stock: Growth rate in dividend = (1.48/0.68)^(1/10)-1 = 8.09% Cost of new common equity, using constant dividend growth model = D1/(P0-Fc)+g where D1 = next expected dividend = D0 (current dividend)*(1+g) P0 = Current price per share Fc = Floatation cost per share g = Growth rate Substituting values in the above formula, cost of new common equity = 1.48*1.0809/(12.50-12.50*15%)+0.0809 = 23.15% WACC: WACC = Cost of debt*Weight of debt+Cost of preferred stock*Weight of preferred stock+Cost of common stock*Weight of common stock = 6.6*130/200+2.51*50/200+23.15*20/200 = 7.23%

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