The Ewing Distribution Company (EDC) is planning a $100 million expansion of its

Question

The Ewing Distribution Company (EDC) is planning a $100 million expansion of its chain of discount service stations to several neighboring states. This expansion will be financed with debt, preferred stock and equity. The firm’s has 20,000 bonds with a $1,000 face value of current debt. The debt has a 12% coupon and 20 years remaining before maturity and is currently selling for $865. Ewing’s marginal tax rate is 40%.
EDC has 100,000 shares of $50 par value $3.50 preferred stock outstanding which has a current market price of $42. Ewing’s common stock paid a dividend of $2.10 per share this year and $2.00 the previous year. The current market price per share is $15, and the investment banking firm will charge a flotation fee of 10% if new shares are sold. The current risk-free rate is 7% and the market’s estimated rate of return is 15%. Ewing’s estimated beta is 1.2. Ewing expects to have $20 million of retained earnings available to finance the expansion.
Ewing’s Balance Sheet
Debt $ 20,000,000
Preferred Stock 5,000,000
Common equity 75,000,000
$ 100,000,000

5. What component weights should you used to compute the WACC?

6. Compute the after tax cost of debt

Explanation / Answer

Here we have to findout the cost of debt, cost of equity and cost of preferred stock. Calculation of cost of debt:                      = (Interest + (MV - PV)/n)/(MV+PV)/2    Interest is 12% on $1,000. Interest is $120    MV(maturity value of the debt is $865)    n is the maturity of the bond that is 20 years. Cost of debt is = (120 +(865 - 1000)/20)/(865+1000)/2                       = (120 - 6.75)/932.5                      = 113.25/932.5                       = 0.1214    Cost of debt before taxes is 12.14% Calculation of cost of preferred stock:                      Cost of preferred stock   = Preferred dividend/Market value of the preferred stock                                                          = $3.50/$42                                                          = 0.833       Cost of preferred stock is 8.33%. Calculation of cost of equity:                Cost of equity   = Current year dividend/Net proceeds + Growth rate       Current year dividend is $2.10.       Previous year dividend is $2       (1+g)   = Current year dividend/Previous year dividend                  = 2.10/2                  = 1.05          g       = 0.05          Growth rate is 5%.    Net proceeds   = Mraket price - Flotation costs                          = $15 - 0.1*15                          = $15 - $1.5                          = $13.5       Cost of equity = 2.10/13.5 + 0.05                            = 0.1556 + 0.05                            = 0.206       Cost of equity is 20.6% Calculation of proprtion of investments:    Total value is $100,000,000    Total value is $100,000,000 Proportion of debt is = Value of debt/Total value                                = $20,000,000/$100,000,000                                = 0.2 Propotion of equiyt is = Value of equity/Total value                                 =75,000,000/100,000,000                                 = 0.75 Proportion of preferred stock   = value of preferred stock/Total value                                               = 5,000,000/100,000,000                                               = 0.05 5. Calculation of WACC:                                 WACC = Cost of debt*(1-Taxes)*proportion of debt + Cost of equity*Proportion of equity + Cost of preferred stock*Proportion of preferred stock                                           = 0.1214*(1-0.4)*0.2 +0.26*0.75 + 0.833*0.05                                           = 0.02428*0.6 + 0.0195 + 0.04165                                           = 0.075718    Therefore WACC is 7.57% 6.       Cost of debt after taxes = Cost of debt before taxes*(1-Tax rate)                                          = 0.1214*(1-0.4)                                          = 0.1214*0.6                                          = 0.7284       Cost of debt after taxes is 7.28%       Cost of debt after taxes is 7.28%

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