You are given the following information concerning Parrothead Enterprises: Debt:

Question

You are given the following information concerning Parrothead Enterprises:

Debt:
9,000 6.2 percent coupon bonds outstanding, with 20 years to maturity and a quoted price of 104. These bonds pay interest semiannually.


Common stock:
225,000 shares of common stock selling for $64.50 per share. The stock has a beta of 0.85 and will pay a dividend of $2.70 next year. The dividend is expected to grow by 5 percent per year indefinitely.

Preferred stock: 8,000 shares of 4.5 percent preferred stock selling at $94 per share.

Market: A 12 percent expected return, a 5 percent risk-free rate, and a 35 percent tax rate.

Component:     R:

Debt (before tax) 10%

Preferred Stock 9%

Common equity 14%

Explanation / Answer

Debt:
Using the BA Financial Calculator, you can easily find out that I/Y=2.9289%, convert that to annual rate being (1+2.9289%)^2-1=5.9436522%
And Debt Value=9000*104=936,000

Common Stock:
As far as the info the problem provides, there're two ways to estimate the cost of equity.
1.Dividend Capitalization Model
Cost of Equity=Dividends per share for next year/current price per share+dividend growth rate=2.7/64.5+0.05=9.1860465%
2.CAPM
Cost of Equity=risk-free rate+beta*(Market Premium)=0.05+0.85*(0.12-0.05)=10.95%
And Common Stock Value=225000*64.5=14,512,500

Preferred Stock:
Price=Par Value*Dividend Rate/Required Return
So, 94=100*4.5%/Required Return which gives Required Return =4.78723%
And Preferred Stock Value=8000*94=752,000

WACC is calculated by the weighted average of three cost computed above. Note, only cost of debt needs tax adjustment.

Since there are two approaches of cost of equity mentioned above, I use the value estimated by CAPM.
(Debt+Common Stock+Preferred Stock=936,000+14,512,500+752,000=16,200,500)

WACC=5.9436522%*(1-0.35)*936,000/16,200,500+10.95%*14,512,500/16,200,500+4.78723%*752,000/16,200,500=0.1025449?10.25%

Hope this helps.

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