A company can issue new 20 year bonds with a coupon rate of 4%, coupons paid sem

Question

A company can issue new 20 year bonds with a coupon rate of 4%, coupons paid semi-annually, a par value of $1,000, for an issue price of $768.85. The company can issue preferred stock that pays a dividend of 6% of par, with a par value of $50, at its current price of $18. The company expects dividends to grow at 3% for the foreseeable future, paid a dividend most recently of $3.00 per share (i.e., D0 = $3.00), and recently traded for $21 per share. The company is funded 40% debt, 5% preferred, and 55% common equity. The tax rate is 40%. What is the company's WACC?

Explanation / Answer

NPV is short for Net Present Value. It refers to the Time Value of Money (which states that a dollar received today is worth more than a dollar received one year from now, because you can invest it) and this is the fundamental basis of finance. The NPV concept is that the value of something (a company, a project, a new piece of equipment, etc) is the present value of the future cash flows it will generate.

To find NPV, you project the future cash flows that you expect the target company to generate, and discount it back to the present using what's called a discount rate.

WACC is short for Weighted Average Cost of Capital, and the WACC is the discount rate used to find the net present value.

To find WACC, you use the weighted average of the cost of capital for your capital structure. The WACC formula is:

[k(e) * (e/(d+e)] + [k(d) * (d/(d+e)) * (1- t)] where:

e = equity
d = debt
k(e) = cost of equity (typical calculated using the CAPM--see below)
k(d) = cost of debt (typically the yield on a company's outstanding bonds)
t = tax rate

So, if a company's capital structure is 30% debt, 70% equity, and it's cost of debt (is 8%, and it's cost of equity is 11%, and it has a 40% tax rate, the WACC would be:

[70% * 11%] + [30% * (8%) * (1 - 40%)] = 9.14%, so you would use 9.14% as the discount rate to find the net present value.

The Capital Asset Pricing Model (CAPM) is the most common way of finding a company's cost of equity. The formula states that:

k(e) = r(f) + B * [r(m) - r(f)] where:

r(f) = risk free rate of return (typically the yield on U.S. Treasury bonds
r(m) = return of the overall market
B = Beta coefficient for the company--if the company is publicly traded, you can find their Beta on Yahoo! Finance under Key Statistics ov the company's stock page

So imagine the risk free rate of return is 5%, the market returns 9%, and the Beta is 1.5, your formula would be:

k(e) = 5% + 1.5 * (9% - 5%)

So your cost of equity k(e) would be 9%

Like I said, it's very difficult to explain over the computer. And there are a lot of different concepts you need to know in order to understand the WACC, which is why my answer was so long and complex.

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