The Imaginary Products Co. currently has debt with a market value of $275 millio
ID: 2653605 • 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 $1,054.14 per bond. The firm also has an issue of 2 million preferred shares outstanding with a market price of $28. 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 8 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?
1) Calculate the Weights for debt, common equity, and preferred equity.
Explanation / Answer
Market value of the Debt = $275 million.
Market value of Preference shares = 2 million * $28 = $56 million.
Market value of Equity = 14 million * $20 = $280 million
Total Market value of the company = $275 + $56 +$280 = $611 million.
Weight of debt = $275 / $611 = 0.45
Weight of preference shares = $56/$611 = 0.0917
Weight of common stock = $280/611 = 0.4583
Cost of debt = 9%(1-tax) = 0.09 (1-0.40) = 0.09*0.6 = 0.054 or 5.4%.
Cost of preference shares = Dividend / market price = $1.2/$28 = 0.043 or 4.3%.
price of the share = Dividend / cost of equity -growth
$20 = $2.20 / (x)-8%
$20 / $2.20 = 1 / (x)-0.08
9.09 = 1 / (x) - 0.08
x - 0.08 = 1 / 9.09
x - 0.08 = 0.11
x = 0.11+0.08 = 0.19 or 19%.
WACC = weight of debt * cost of debt + weight of preference * cost of prefernce + weight of equity * cost of equity
= 0.45 * 5.4% + 0.0917 * 4.3% +0.4583 *19%
= 2.43 + 0.3943 + 8.7077
= 11.532%
Therefore, the WACC is 11.532%.
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