Consider a company with the following capital structure: Capital Structure Book

Question

Consider a company with the following capital structure:

Capital Structure
Book Value Market Value
Debt $ 100 million $ 106 million
Preferred stock 50 million 52 million
Common Equity 350 842
Total invested capital $500 million $1,000 million

Some other characteristics of the company are:

Beta of the common stock 1.07
Expected long-term growth rate 6.0%
Quality of debt Aa
Quality of preferred shares A
Expected dividend yield on common stock 3.7%
Marginal Income tax rate 35.0%
Current preferred stock price per share $50.00
Perpetual dividend on preferred (per share) $3.75
The prevailing financial conditions are:

Quality Yields on Newly Issued Bonds by Quality
Aaa 6.9%
Aa 7.0
A 7.2
Baa 7.5

Risk free rate 6.5%
Equity risk premium over bonds 2.7%
Expected return on stock market index 9.5%

What is the company’s weighted average cost of capital?

Explanation / Answer

From the data, each of the component costs can be found and subsequently, the weighted average cost of capital can be calculated/ The cost of debt is 7.0% pretax as this is the cost of newly issued bonds of equal quality (Aa rating). The cost of preferred stock is: rp = DIVP / PPS = $3.75/$50.00 = 7.5% The cost of common equity capital which is the cost of equity (rCE), can be calculated in one of three ways: 1. rCE = rD + rERP = 7.0% + 2.7% = 9.7% 2. rCE = DIV1/PCS + gDIV = E(Dividend Yield) + gDIV = 3.7% + 6.0% = 9.7% 3. rCE = rF + ßCS(rM– rF) = 6.5% + 1.07(9.5 – 6.5) = 9.7% Therefore, the weighted average cost of capital of the firm under these conditions is: rW = (1-t)rD(vD/vA) + rp(vP/vA) + rCE(vCE/vA) = (1-.35)(.07)(106 million/1,000 million) +.075(52million/1,000 million) +.097(842 million/1,000 million) = 9.0%

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