Consider the following information for Evenflow Power Co., HINT: Use the Securit

Question

Consider the following information for Evenflow Power Co.,

HINT: Use the Security Market Line to get the cost of the common equity. Use the perpetuity equation to get the cost of preferred equity. Don't forget to adjust the cost of debt for taxes (and don't convert the YTM into an EAR, but leave it as an APR). You will also need to calculate the market value of all three types of securities to get the capital structure weights.

  Debt: 3,000 7.5 percent coupon bonds outstanding, $1,000 par value, 18 years to maturity, selling for 104 percent of par; the bonds make semiannual payments and have a YTM of 7.1%.   Common stock: 63,000 shares outstanding, selling for $62 per share; the beta is 1.17.   Preferred stock: 10,500 shares of preferred stock outstanding, paying 6 percent on $100 of par, and currently selling for $105 per share.   Market: 8.5 percent market risk premium and 5.5 percent risk-free rate.

Explanation / Answer

Step 1:

1) Cost of Common Stock = Rf + (Rm-Rf)*Beta

Cost of Common Stock = 5.5 + 8.5*1.17

Cost of Common Stock = 15.445%

2) Cost of Preferred Stock = 6/105

Cost of Preferred Stock = 5.714286%

3)

Before Tax Cost of Debt = 7.1 %

After Tax Cost of Debt = 7.1*(1-33%)

After Tax Cost of Debt =4.757%

Step 2:

Market Value of Common Stock = 63000*62 = $ 3906000

Market value of Preferred Stock =10500*105 = $ 1102500

Market Value of Bond = 3000*1000*104% = $ 3120000

Total Market Value = 3906000 + 1102500 + 3120000 = 8128500

Weight of Common Stock = 3906000/8128600 = 39060/81285

Weight of Preferred Stock = 1102500/8128600 = 11025/81285

Weight of Debt = 3120000/8128600 = 31200/81285

Step3:

WACC = Weight of Common Stock* Cost of Common Stock + Weight of Preferred Stock* Cost of Preferred Stock + Weight of Debt* After Tax cost of Debt

WACC = 39060/81285* 15.445 + 11025/81285* 5.714286 + 31200/81285* 4.757

WACC = 10.02%

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