Cypress Corporation has a target capital structure of 60% debt, 15% preferred st
ID: 2670600 • Letter: C
Question
Cypress Corporation has a target capital structure of 60% debt, 15% preferred stock, and 25% common stock. Currently Cypress has a capital structure of 75% debt, 10% common stock, and 15% preferred stock. The after tax cost of debt is 6%. The preferred stock has a par value of $100 per share, a $9 per share dividend, and a market price of $80 per share. The common stock of Cypress trades at $84 per share and has a projected dividend (D1) of $3.36. The stock price and dividend are expected to continue to grow at 12% for the foreseeable future. The CFO expects the company to have $590,000 available from retained earnings.What is the weighted average cost of capital (WACC) for Cypress?
Explanation / Answer
According to the given information,
Weight of debt (Wd) = 60%
Weight of preferred stock (Wp)= 15%
Weight of common stock (Wc)= 25%
After-tax cost of debt (Kd) = 6%
Annual preferred dividend = $9
Market price per preferred stock = $80
Dividend for year-1 on common stock = $3.36
Market price per share of common stock = $84
The cost of preferred stock is calculated as
Kp = Annual preferred dividend / Market price per preferred stock
= $9 / $80
= 0.1125 or 11.25%
Therefore, the cost of preferred stock is 11.25%
Computing the cost of equity:
According to Dividend discount model,
Ke = (D1 / P0) + g
= ($3.36 / $84) + 0.12
= 0.04 + 0.12
= 0.16 or 16%
Therefore, the cost of equity is 16%
While calculating the WACC, we should use the target weights but not the current weights. The target capital structure is the capital structure that will optimize the company's stock price. It is also the capital structure that minimizes the Company's weighted average cost of capital.
The formula for calculating the WACC is
WACC = (Wd * Kd) + (Wp * Kp) + (We * Ke)
= (0.6 * 0.06) + (0.15 * 0.1125) + (0.25 * 0.16)
= 0.036 + 0.016875 + 0.04
= 0.0929 or 9.3%
Therefore, the weighted average cost of capital is 9.3%
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