You are estimating the WACC for PTY Enterprises with the following information:

Question

You are estimating the WACC for PTY Enterprises with the following information:

Debt: 7,000 bonds outstanding with 7.5 percent annual coupon bonds, payable semiannually, on a $1,000 par, and the quoted price of 108 percent.

Common stock: 180,000 shares of common stock selling for $60 per share. The stock has a beta of 0.90 and will pay an annual dividend of $2.80 next year. The dividend is expected to grow by 6 percent per year indefinitely.

Preferred stock: 8,000 shares of 5.5 percent preferred stock with $100 par selling at $94 per share.

Market: A 12 percent expected return on the market, a 5 percent risk-free rate, and a 35 percent tax rate.

Calculate the WACC for PTY Enterprises.

Explanation / Answer

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere. Companies raise money from a number of sources: common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, and so on. Different securities, which represent different sources of finance, are expected to generate different returns. The WACC is calculated taking into account the relative weights of each component of the capital structure. The more complex the company's capital structure, the more laborious it is to calculate the WACC. Companies can use WACC to see if the investment projects available to them are worthwhile to undertake.[1] In general, the WACC can be calculated with the following formula[2]: ext{WACC} = rac{sum_{i=1}^N r_i cdot MV_i }{sum_{i=1}^N MV_i} where N is the number of sources of capital (securities, types of liabilities); r_i is the required rate of return for security i; MV_i is the market value of all outstanding securities i. Tax effects can be incorporated into this formula. For example, the WACC for a company financed by one type of shares with the total market value of MV_e and cost of equity R_e and one type of bonds with the total market value of MV_d and cost of debt R_d, in a country with corporate tax rate t is calculated as: ext{WACC} = rac{MV_e}{MV_d+MV_e} cdot R_e + rac{MV_d}{MV_d+MV_e} cdot R_d cdot (1-t)

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