R.S. Green has 250,000 shares of common stock outstanding at a market price of $

Question

R.S. Green has 250,000 shares of common stock outstanding at a market price of $28 a share. Next year's annual dividend is expected to be $1.55 a share. The dividend growth rate is 2 percent. The firm also has 7,500 bonds outstanding with a face value of $1,000 per bond. The bonds carry a 7 percent coupon, pay interest semiannually, and mature in 7.5 years. The bonds are selling at 98 percent of face value. The company's tax rate is 34 percent. What is the firm's weighted average cost of capital?

Explanation / Answer

Cost of equity can be calculated using dividend growth model as follows: Price = Dividend next year / (Cost of equity - Growth rate) Cost of equity = Dividend next year / Price + growth rate = 1.55/28 + 0.02 = 7.54% Cost of debt can be calculated as the yield to maturity on the bond. The YTM is the discount rate which makes the present value of cash flows equal to the current bond value Cash flows are as follows: Period 1 to 14: 0.07 * 1000 / 2 = 35 Period 15: 1000 + 35 = 1035 Present value of the bond = 0.98*1000 = 980 The YTM (using a financial calculator) = 3.68% Market value of equity = 250000 * 28 = 7,000,000 Market value of debt = 7500 * 980 = 7,350,000 WACC = % of debt * Cost of debt * (1-tax rate) + % of equity * Cost of equity = (7,350,000/14,350,000) * 3.68 * (1-0.34) + (7,000,000/14,350,000) * 7.54 = 5.4%

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