As CFO of Mickey’s Mullets, Inc., you are trying to determine the firm’s weighte

Question

As CFO of Mickey’s Mullets, Inc., you are trying to determine the firm’s weighted average cost of capital (WACC). You have gathered the following information:

1. The firm has 2,000 bonds, 35,000 preferred shares, and 100,000 common shares of stock outstanding.

2. The bonds were 20 years bonds when they were issued 2 years ago, have a 9% coupon rate, paid annually, and a $1,000 face value. The bonds currently have a yield to maturity of 6.5881%.

3. The preferred stock pays a $5.25 annual dividend and currently has a dividend yield of 7.5%.

4. The firm just paid a $1.20 dividend on the common stock yesterday, which has a beta of 0.95, and expects to maintain a constant 7 percent growth rate in dividends.

5. You know the yield on short-term U.S. Treasuries is 5.3%, the historical market risk premium is 6 percent, and the firm has a marginal tax rate of 40 percent.

Explanation / Answer

Bond years to maturity 18 Current yield to maturity 6.5881% Annual coupont at 9% $90 Present value of cash flow=(Cash flow)/((1+i)^N) i=discount rate=6.5881%=              0.065881 N=Year of cash flow N A A/(1.065881^N) Year Cash flow PV of cash flow 1 $90 84.43719327 2 $90 79.21821786 3 $90 74.32182191 4 $90 69.72806712 5 $90 65.41824755 6 $90 61.37481347 7 $90 57.58129985 8 $90 54.02225938 9 $90 50.68319951 10 $90 47.55052348 11 $90 44.6114749 12 $90 41.85408587 13 $90 39.2671282 14 $90 36.8400677 15 $90 34.56302129 16 $90 32.42671676 17 $90 30.422455 18 $1,090 345.6762367 Total 1249.99683 A Current market Price of Bond $                1,250 B Total number of Bonds 2000 C=A*B Total market value of Bonds $        2,499,994 Marginal tax rate=40%                       0.40 X Cost of Bond=6.5881*(1-0.4)                       3.95 percent A Dividend yield of Preferred shares 7.50% B Annual Dividend $5.25 C=B/A Market price of Preferred share $70.00 D Number of preferred shares 35000 E=C*D Total market value of preferred shares $2,450,000 Y Cost of preferred shares                       7.50 percent Required Return on Common stock=Rf+Beta*(Rm-Rf) Rf=Risk free rate of return=5.3% Beta=0.95 (Rm-Rf)=Market risk premium=6% Required Return on Common stock= 11.00 percent (5.3+(0.95*6) Price of common stock=D1/(R-g) D1=Next years dividend=D0*(1+g) D0=Just paid dividend=$1.2 g=growth rate of dividend=7%=0.07 D1=1.2*(1+0.07) $                1.284 A Price of common stock=1.284/(0.11-0.07) $                32.10 B Number of common stock 100000 C=A*B Total Market value of common stock $        3,210,000 Z Cost of equity 11% Total market value of capital= $        8,159,994 (=2499994+2450000+3210000) P Weight of Bond =2499994/8159994) 0.30637201 Q Weight of preferred shares=(2450000/8159994) 0.300245331 R Weight of Equity =(3210000/8159994)= 0.393382659 W=P*X+Q*Y+R*Z Weighted average cost of capital (WACC)                       7.79 Percent WACC=7.79%

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