5.3. Salem Company has the following capital structure: 4.0 million shares of st

Question

5.3. Salem Company has the following capital structure: 4.0 million shares of stock, selling at $29 each, with = 1.3; zero-coupon bonds with face amount $65 million, maturing in 8 years, with yield to maturity 7.0%; and 700,000 shares of preferred stock selling at $15 per share, paying a dividend of 40¢ per quarter. The income tax rate of Salem is 33%. The risk-free rate is 2.8%, and the expected return on the market 14%. Do not use the original issue discount. Find the weighted average cost of capital for Salem. Answer: (14.02%). Show solutions

Explanation / Answer

WACC= 14.02%

Cost of equity=Risk-free rate+Beta(Expected market return-Risk-free rate)                              =0.028+1.3(0.14-0.028) = 0.1736 ie. 17.36% Value of zero coupon bond is found using the formula, FV/(1+r)^8=65/(1.07)^8 Value of zero coupon bond 37.83059 Cost of zero coupon bond= 0.07(1-0.33)=0.0469      (After-tax cost) Cost of preference shares= 40 cents*4=160 c or $1.6 =1.6/15 = 0.1067

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