As a newly hired financial analyst, your first job at VersaLife Corporation is t

Question

As a newly hired financial analyst, your first job at VersaLife Corporation is to calculate the company's cost of capital. The present capital structure, which is considered optimal, is as follows:

Market Value

Debt $80 million

Preferred Stock $10 million

Common Equity $110 million

If VersaLife Corporation issues new debt, then the bond market expects a yield of 7.5%. Preferred stock is trading for $96, has a $100 par value and pays an annual dividend of 8% (the next dividend is due in one year). Common equity has a beta of 1.20, the market risk premium is 5%, and the risk-free rate is 3%. If the firm's tax rate is 40%,what is the weighted average cost of capital?

Explanation / Answer

Cost of debt = yield*(1-tax rate) = 7.5%*(1-40%) = 4.5%

Cost of preferred stock = dividend/price = 8/96 = 8.33%

Cost of common equity = risk free rate + beta * market risk premium = 3%+1.2*5% = 9%

WACC = cost of debt*weight of debt + cost of preferred stock*weight of preferred stock + cost of common equity/weight of common equity = 4.5%*80/(80+10+110) + 8.33%*10/(80+10+110) + 9%*110/(80+10+110) = 7.17%

Hope this helped ! Let me know in case of any queries.

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