Debt: 10,300 7.3 percent coupon bonds outstanding, with 22 years to maturity and

Question

Debt: 10,300 7.3 percent coupon bonds outstanding, with 22 years to maturity and a quoted price of 107.25. These bonds pay interest semiannually.

Common stock: 290,000 shares of common stock selling for $65.80 per share. The stock has a beta of .98 and will pay a dividend of $4.00 next year. The dividend is expected to grow by 5.3 percent per year indefinitely.

Preferred stock: 9,300 shares of 4.65 percent preferred stock selling at $95.30 per share.

Market: A 10.7 percent expected return, a risk-free rate of 5.3 percent, and a 38 percent tax rate.

Required: Calculate the WACC for Parrothead Enterprises

This question was previously incorrectly answered with 10.28

Explanation / Answer

We will begin by finding the market value of each type of financing. We find:

MVD= 9,800($1,000)(1.060) = $10,388,000

MVE= 265,000($65.30) = $17,304,500

MVP= 8,800($94.80) = $834,240

And the total market value of the firm is:

V= $10,388,000 + $17,304,500 + $834,240= $28,526,740

Now, we can find the cost of equity using the CAPM. The cost of equity is:

RE1= 0.053 + 0.93(0.112 – 0.053)

RE1= 0.1079, or 10.79%

We can also find the cost of equity, using the dividend discount model. The cost of equity with the dividend discount model is:

RE2= ($3.50 / $65.30) + 0.053

RE2= 0.1066, or 10.66%

Both estimates for the cost of equity seem reasonable, so we will use the average of the two. The cost of equity estimate is:

RE= (0.1079 + 0.1066)/2

RE= 0.1073, or 10.73%

The cost of debt is the YTM of the bonds, so:

P0= $1,060.00 = $36.50(PVIFAR%,44) + $1,000(PVIFR%,44)

R= 3.39%

YTM = 3.39%×2

YTM = 6.78%

And the after-tax cost of debt is :

RD = (1 – 0.38)(0.0678)RD= 0.0420, or 4.20%

The cost of preferred stock is:

RP= $4.65 / $94.80RP= 0.0491 or 4.91%

Now, we have all of the components to calculate the WACC. The WACC is :

WACC = 0.0420($10,388,000/$28,526,740) + 0.0491($834,240/$28,526,740)+ 0.1073($17,304,500/$28,526,740)

WACC = 0.0818, or 8.18%

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