Debt: 7,000 7.5 percent coupon bonds outstanding, with 20 years to maturity, and

ID: 2759048 • Letter: D

Question

Debt:7,000 7.5 percent coupon bonds outstanding, with 20 years to maturity, and a quoted price of 108. These bonds pay interest semiannually.

Common Stock:180,000 shares of common stock selling for $60 per share. The stock has a beta of 0.90 and will pay a dividend of $2.80 next year. The dividend is expected to grow by 6 percent per year indefinitely.

Preferred Stock:8,000 shares of 5.5 percent preferred stock selling at $94 per share.

Market:A 12 percent expected return, a 5 percent risk-free rate, and a 35 percent tax rate.

Calculate the WACC for Parrothead Enterprises.

Explanation / Answer

Cost of debt = Interest rate * (1-t) / bond *1.08

= {$7,000*0.075 * (1-0.35)} / 7,000*1.08

= $525* 0.65 / $7,560

= $341.25 / $7,560

= 4.5%

Return on common stock = dividend*(1+beta) / selling price of share

= $2.80 *( 1+ 0.90) / $60

= 8.87%

Now, cost of common stock = Dividend / return –growth

= $2.80 / 8.87-6

= $97.56

CAPM return = Rf + (Rm –Rf)

= 0.05 + 0.90 (0.12-0.05)

= 11.3%

Preferred stock = 5.5% (given)

Calculation of WACC:

Source of capital

value of capital

Weights

cost of capital

WACC

Bonds

$ 7,000

0.001

0.045

0.000

Common stock (180000*60)

$ 10,800,000

0.934

0.113

0.106

Preferred stock (8000*94)

$ 752,000

0.065

0.055

0.004

$ 11,559,000

1.000

0.109

WACC = 0.109 or 10.9%