You are given the following information concerning Parrothead Enterprises: Debt:

Question

You are given the following information concerning Parrothead Enterprises: Debt: 10,800 7.3 percent coupon bonds outstanding, with 22 years to maturity and a quoted price of 108.5. These bonds pay interest semiannually. Common stock: 315,000 shares of common stock selling for $66.30 per share. The stock has a beta of 1.04 and will pay a dividend of $4.50 next year. The dividend is expected to grow by 5.3 percent per year indefinitely. Preferred stock: 9,800 shares of 4.65 percent preferred stock selling at $95.80 per share. Market: An expected return of 10.2 percent, a risk-free rate of 5.15 percent, and a 38 percent tax rate. Calculate the WACC for Parrothead Enterprises. (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) WACC %?

Explanation / Answer

cost of debt (after tax)

cost of debt = annual coupon + [(par value - market value) / number of maturity] / [(par value + market value) /2 ]

= $73 + [(1000 - 1085) / 22] / [(1000 + 1085) /2 ]

= [$73 - 3.8636] /1042.5

=69.1364 / 1042.5

= 6.56%

Cost of debt after tax = 6.56% * (1 - 0.38)

= 4.07%

cost of equity

By using Dividend discount model:

Stock price = next year dividend / (required rate - growth rate)

$66.30 = $4.5 / (required rate - 0.053)

$66.30* required rate - $3.5139 = $4.5

$66.30* required rate = $4.5 + $3.5139

$66.30* required rate = $8.0139

required rate =12.09%

By using CAPM :

required rate of return = risk free rate + beta* ( Market expected return - risk-free rate)

=  5.15% + 1.04 * ( 10.2% - 5.15%)

=  5.15% + 5.252%

= 10.40%

By taking the average of both the cost of equity = [12.09% + 10.40%] / 2

=11.25%

Cost of preferred stock

Cost of preferred stock = dividend / market price

= $4.65 /  $95.80

=4.85%

WACC = Market value of Debt / Total value of frim * cost of debt after tax + Market value of equity / Total value of frim * cost of equity + Market value of preferred / Total value of frim * cost of preferred stock

=  $11718000 /  $33541340 * 4.07% + $20884500 /  $33541340 * 11.25% + $938840 / $33541340 *4.85%

= 0.3494* 4.07% + 0.6226* 11.25% +   0.0280* 4.85%

= 1.4221% + 7.0043% + 0.1358%

= 8.56%

Note:- Total market value of firm :

Market value of debt = 10800 * $1085 = $11718000

Market value of equity =  315,000 * $66.30 = $20884500

Market value of preferred =  9,800 * $95.80 = $938840

   Total market value of firm = $33541340

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