You are given the following information for Watson Power Co. Assume the company’

Question

You are given the following information for Watson Power Co. Assume the company’s tax rate is 40 percent. Debt: 7,000 coupon bonds outstanding, yielding 5.70 percent and paying a 6.2 percent coupon, $1,000 par value, 15 years to maturity, selling for 105 percent of par; the bonds make semiannual payments. Common stock: 340,000 shares outstanding, selling for $52 per share; the beta is 1.08. Preferred stock: 12,000 shares of 5 percent preferred stock outstanding, currently selling for $72 per share. Market: 8 percent market risk premium and 4.2 percent risk-free rate. What is the company's WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Explanation / Answer

Cost of Common Stock = Risk-free rate + Beta * Market Risk Premium

= 4.2 + 1.08 * 8

= 12.84 %

Cost of Preferred Stock = Dividend Per Share / Net Proceeds

= 5 / 72   

= 0.0694 i.e., 6.94 %

(Dividend Per Share = 5 % of Par Value i.e., 5 % of 100 = $ 5. Dividend is paid on the par value / paid-up value. Assuming Par value / Paid-up value of Preferred Stock to be $ 100)

Cost of debt =[ Interest + { (Redemption Value - Net Proceeds) / Number of years to maturity } ] / (Redemption Value + Net Proceeds) / 2

= [ 7000 * 1000 * 6.2 % * 1 / 2 + { ( 7000000 - 7350000) / 30 } ] / (7000000 + 7350000) / 2

= [ 217000 - 11666.67 ] / 7175000

= 205333.33 / 7175000

= 0.02862 i.e., 2.86 % (approx)

Cost of debt (after-tax) = 2.86 * ( 1 - 0.40) = 1.717 %

Weights of Common Stock, Debt and Preferred Stock

Common stock = 340000 * 52 / (340000 * 52 + 7000 * 1050 + 12000 * 72)

= 17680000 / 25894000

= 0.68

Debt = 7000 * 1050 / (340000 * 52 + 7000 * 1050 + 12000 * 72)

= 7350000 / 25894000

= 0.28

Preferred Stock = 1 - (0.68 + 0.28) = 1 - 0.96 = 0.04 (approx)

Calculation of WACC:-

Conclusion:- The company's WACC = 9.49 % (approx)

NOTE:- WACC is calculated using the market value weights of Common stock, Debt and Preferred Stock.

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