Given the following information for Lightning Power Co., find the WACC. Assume t

Question

Given the following information for Lightning Power Co., find the WACC. Assume the company’s tax rate is 35 percent.

Debt: 8,000 6.5 percent coupon bonds outstanding, $1,000 par value, 25 years to maturity, selling for 106 percent of par;the bonds make semiannual payments.

Common stock: 310,000 shares outstanding, selling for $57 per share; the beta is 1.05.

Preferred stock: 15,000 shares of 4 percent preferred stock outstanding, currently selling for $72 per share.

Market: 7 percent market risk premium and 4.5 percent risk-free rate.

1. If a firm plans to issue debt to finance their next project then, they should discount the project's cash flows by:

2. The WACC is:

3. What is the weighted cost of capital?

4. Equity is what portion of the capital structure of the firm?

5. The weighted cost of debt is?

Explanation / Answer

First of all we need to find market value of each type of financing:

MVD = 8000*$1000*1.06=$8,480,000

MVE = 310,000*$57 = $17,670,000

MVP = 15000*$72 =$1,080,000

Total Value of the firm = $8,480,000+$17,670,000+$1,080,000 = $27,230,000

Formulla for WACC

KWACC =(WE*KE)+(WD*KD after tax)+(WP*KP)

WE =$17,670,000/$27,230,000=0.6489

WD=$8,480,000/$27,230,000=0.3114

WP=$1,080,000/$27,230,000=0.0397

Using CAPM Cost of Equity KE= Risk free rate+ (Market risk premium*Beta)

=4.5%+(7%*1.05)

=11.85%

Cost of Preference Share KP = Annual Dividend/Current Market Price

=$4/$72

= 5.55%

Cost of Debt KD is YTM of Bond so:Debt: 8,000 6.5 percent coupon bonds outstanding, $1,000 par value, 25 years to maturity, selling for 106 percent of par;the bonds make semiannual payments

P0 =$1060=$32.5(PVIFAR%,50) +$1000((PVIFR%,50)

Using Interpolation or trial rate method

R = 3.02%

YTM = 3.02% *2 =6.04%

After tax cost of debt =0.0604(1-0.35) = 0.03926= 3.926%

Finally WACC is calculate as below

KWACC =(WE*KE)+(WD*KD after tax)+(WP*KP)

=(0.6489*0.1185)+(0.3114*0.03926)+(0.0397*0.0555)

= 0.09132 or 9.13%

1. If a firm plans to issue debt to finance their next project then, they should discount the project's cash flows by WACC.

2.The WACC is The arithmetic average cost of raising capital.

3. What is the weighted cost of capital is 9.13% as calculated above.

4. Equity portion of the capital structure of the firm is 0.6489.

5. The weighted cost of debt after tax is (0.3114*0.03926) = 0.0122 or 1.22 %

and before tax is (0.3114*0.0604) = 0.0188 or1.88%

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