Erna Corp. has 6 million shares of common stock outstanding. The current share p

Question

Erna Corp. has 6 million shares of common stock outstanding. The current share price is $72, and the book value per share is $7. Erna Corp. also has two bond issues outstanding. The first bond issue has a face value of $70 million, has a coupon rate of 7 percent, and sells for 97 percent of par. The second issue has a face value of $50 million, has a coupon rate of 8 percent, and sells for 106 percent of par. The first issue matures in 22 years, the second in 6 years.

Suppose the most recent dividend was $4.40 and the dividend growth rate is 6 percent. Assume that the overall cost of debt is the weighted average of that implied by the two outstanding debt issues. Both bonds make semiannual payments. The tax rate is 35 percent. What is the company’s WACC?

Explanation / Answer

To calculate cost of equity, we use the formula, P = D/Ke-g

P = Current stock price

D = dividend

Ke = cost of equity

g = growth rate

72 = 4.4 / Ke -.06

Ke = 4.4/72 + .06 = 12.11%

To calculate WACC we find the weights of equity & debt using market value of each:

Market Value of Equity = 6000000 * $72 = $432000000

Market value of first bond = $70000000 * 97% = $67900000

Market value of second bond = $50000000 * 106% = $53000000

Total market value = $552900000

WACC = 12.11% * 432/552.9 + 7%(1-.35) * 67.9/552.9 + 8%(1-.35) * 53/552.9 4.84

= 9.46% + .56% + .498% = 10.52%

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