A company can issue new long-term debt at par ($1,000). The bond matures in twen

Question

A company can issue new long-term debt at par ($1,000). The bond matures in twenty years. The bond carries a coupon of 4.5%, coupons paid semiannually. The company expects to pay a dividend of $2.75 next year (i.e., D1=$2.75). The company expects dividends to grow at 4% for the foreseeable future. The company stock closed yesterday at $18.25. The company finances projects with 30% debt and 70% common equity. The company does not use preferred stock. The company is in the 40% tax bracket.    What is the weighted average cost of capital (WACC) for the company?

Explanation / Answer

Hi,

Please find the detailed answer as follows:

Cost of Debt:

Nper = 20*2 = 40 (indicates the period over which interest payments are made)

FV = 1000 (indicates the face value of bonds)

PMT = 1000*4.5%*1/2 = 22.5 (indicates semi-annual interest payment)

PV = 1000 (indicates current issue price)

Rate = ? (indictates cost of debt)

After Tax Cost of Debt = Rate(Nper,PMT,PV,FV)*2*(1-Tax Rate) = Rate(40,22.5,-1000,1000)*2*(1-40%) = 2.7%

Cost of Equity = Dividend/Equity = 2.75/18.25 = 15.07%

WACC = Weight of Debt*After Tax Cost of Debt + Weight of Equity*Cost of Equity = .30*2.70 + .70*15.07 = 11.358% or 11.36%

Answer is 11.358% or 11.36%.

Thanks.

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