The Imaginary Products Co. currently has debt with a market value of $275 millio
ID: 2383890 • Letter: T
Question
The Imaginary Products Co. currently has debt with a market value of $275 million outstanding. The debt consists of 9 percent coupon bonds (semiannual coupon payments) which have a maturity of 15 years and are currently priced at $886.55 per bond. The firm also has an issue of 2 million preferred shares outstanding with a market price of $14. The preferred shares pay an annual dividend of $1.20. Imaginary also has 14 million shares of common stock outstanding with a price of $20.00 per share. The firm is expected to pay a $2.20 common dividend one year from today, and that dividend is expected to increase by 9 percent per year forever. If Imaginary is subject to a 40 percent marginal tax rate, then what is the firm’s weighted average cost of capital?
a) Calculate the Weights for debt, common equity, and preferred equity.
b) Calculate the cost of debt.
c) Calculate the cost of preferred equity.
d) Calculate the cost of common equity.
e) What is the firm’s weighted average cost of capital?
Explanation / Answer
Debt = $275,000,000 (given)
Preferred equity = $14 x 2,000,000 = $28,000,000
Common equity = $20 x 14,000,000 = $280,000,000
Total capital = $583,000,000
xDebt = 275/583 = 0.47169
xps = 28/583 = 0.0480
xcs = 280/583 = 0.4802
Cost of debt:
YTM = 0.1052
N = 15 x 2 = 30
PV = -886.55
PMT = (.09 x $1,000) / 2 = 45
FV = 1000
I/YR = 5.26x 2 = 10.52
Cost of preferred equity:
Kpe = D/P = 1.2/14 = 0.0857
Cost of common equity
Ke =D/P +g = (2.20 /20 )+0.09 =.20
WACC formula.
WACC = xdebt *kdebt (1-t) +xpe *kpe +xce *ke
WACC = (0.47169 *0.1052 * (1-0.4) + (0.0480*0.0857) + (0.4802*0.20) = 0.1299 or 12.99 %
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