A company you are researching has a common stock with a beta of 1.5. Currently,

Question

A company you are researching has a common stock with a beta of 1.5. Currently, Treasury Bills yield 3.2%, and the market portfolio offers an expected return of 12.5%. The company finances 35% of its assets with debt that has a yield to maturity of 7%. The firm also uses preferred stock to finance 15% of its assets. The preferred stock has a current price of $10 per share and pays a level $2 dividend. The firm is in the 33% tax bracket. What is the weighted average cost of capital? a.) 13.22% b.) 11.43% c.) 10.94% d.) 14.89%

Explanation / Answer

Cost of equity, Ke = Risk-free (T-bill) rate + Beta x (Market return - Risk-free rate)

= 3.2% + 1.5 x (12.5 - 3.2)% = 3.2% + 1.5 x 9.3% = (3.2 + 13.95)% = 17.15%

Cost of debt, Kd = Yield to maturity x (1 - Tax rate) = 7% x (1 - 0.33) = 7% x 0.67 = 4.69%

Cost of preferred stock, Kp = Dividend / Share price = $2 / $10 = 0.2, or 20%

Proportion of equity = (100 - 35 - 15)% = 50%

WACC = Proportion of equity x Ke + Proportion of debt x Kd + Proportion of preferred stock x Kp

= 50% x 17.15% + 35% x 4.69% + 15% x 20%

= (8.58 + 1.64 + 3)% = 13.22%

Correct option (a)

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