The following information is available concerning a firm\'s capital: Debt: Five
ID: 2705917 • Letter: T
Question
The following information is available concerning a firm's capital:
Debt: Five thousand bonds with a face value of $1000 and an initial 20 year term were issued five years ago with a coupon rate of 8%. Today these bonds are selling for $846.30.
Preferred stock: Twenty thousand shares of common stock paying an annual dividend of $9.50 are outstanding. The shares currently trade at $79.16
Common equity: Two hundred thousand shares of common stock are outstanding which are now selling for $22.50 per share. An annual dividend of $1.70 was just paid and is expected to grow indefinitely at 6%.
Target Capital Structure: The firm's target capital structure is of 30% debt, 20% preferred stock, and 50% equity.
The firm can issue any type of security without paying flotation costs. The combined federal and state tax rate is 40%.
Calculate the firm's WACC based on its
a. Target capital structure and market returns
b. Market value based capital structure and market returns
Explanation / Answer
Yield of bonds can be calculated in Excel as =RATE(15,80,-846.3,1000). This is equal to 10.02%
Cost of debt = yield *(1-tax rate) = 10.02%*(1-40%) = 6.01%
Cost of preferred stock = 9.50/79.16 = 12%
Cost of common equity = 1.7*(1+6%)/22.50 + 6% = 14.01%
a. WACC based on target capital structure = 30%*6.01% + 20%*12% + 50%*14.01% = 11.21%
b. WACC based on market value based capital structure
Market value of Debt = 5000*846.3 = 4,231,500
Market value of preferred stock = 20,000*79.16 = 1,583,200
Market value of common equity = 200,000*22.50 = 4,500,000
Total market value of firm capital = 4,231,500 + 1,583,200 + 4,500,000 = 10,314,700
So weight of debt = 4,231,500/10,314,700 = 41.02%
Weight of preferred stock = 1,583,200 / 10,314,700 = 15.35%
Weight of common equity = 4,500,000/10,314,700 = 43.63%
WACC based on market value based capital structure = 41.02%*6.01% + 15.35%*12% + 43.63%*14.01% = 10.42%
Hope this helped ! Let me know in case of any queries.
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