Great Corporation has the following capital situation. Debt: One thousand bonds

Question

Great Corporation has the following capital situation. Debt: One thousand bonds were issued five years ago at a coupon rate of 11%. They had 20-year terms and $1,000 face values. They are now selling to yield 9%. The tax rate is 37% Preferred stock: Two thousand shares of preferred are outstanding, each of which pays an annual dividend of $7.50. They originally sold to yield 15% of their $50 face value. They're now selling to yield 11%. Equity: Great Corp has 108,000 shares of common stock outstanding, currently selling at $18.48 per share. Use the risk premium approach and assume a 3% risk premium.

Can you please show the work/ formulation?

Explanation / Answer

Based on the information below, calculate the weighted average cost of capital. So the question is asking for the weighted average cost of capital

Present Value of Bond = pv(rate,nper,pmt,fv)

rate = 9%

nper = 20-5 = 15

pmt = 11%*1000 = 110

fv = 1000

Present Value of Bond = pv(9%,15,110,1000)

Present Value of Bond = 1161.21

Selling Price of Prefered Share = annual dividend/yield rate

Selling Price of Prefered Share = 7.5/11%

Selling Price of Prefered Share = $ 68.18

Use the risk premium approach

Step 1:

1)

Cost of Equity = Yield rate of debt +  risk premium

Cost of Equity = 9% + 3%

Cost of Equity =12%

2) Cost of Preferred Stock = 11%

3) Before Tax Cost of Debt = 9 %

After Tax Cost of Debt = Before Tax Cost of Debt *(1-tax rate)

After Tax Cost of Debt = 9*(1-37%)

After Tax Cost of Debt = 5.67%

Step 2:

Market Value of Common Stock = 108000*18.48 = $ 1,995,840

Market value of Preferred Stock = 2000*68.18182 = $ 136,363.64

Market Value of Bond = 1000*1161.21 = $ 1,161,210

Total Market Value = $ 3293413.64

Weight of Common Stock = 1995840/3293413.64 = 60.60%

Weight of Preferred Stock = 136363.64/3293413.64 = 4.14%

Weight of Debt = 1161210/3293413.64 = 35.26%

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 = 60.60%*12 + 4.14%*11 + 35.26%*5.67

WACC = 9.73%

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