Consider the following information for Evenflow Power Co., Debt: 3,500 5.5 perce

Question

Consider the following information for Evenflow Power Co., Debt: 3,500 5.5 percent coupon bonds outstanding, $1,000 par value, 22 years to maturity, selling for 102 percent of par; the bonds make semiannual payments. Common stock: 84,000 shares outstanding, selling for $55 per share; the beta is 1.19. Preferred stock: 10,000 shares of 4.5 percent preferred stock outstanding, currently selling for $103 per share. Market: 7 percent market risk premium and 4.5 percent risk-free rate. Assume the company's tax rate is 33 percent. Required: Find the WACC. (Do not round your intermediate calculations.) 8.37% 8.99% 8.3% 8.2% 8.7%

Explanation / Answer

Given that time to maturity of bond = 22 years
Number of coupon payments = t * 2 = 22 * 2 = 44
N = 44
coupon payments = 1000 * 5.5% / 2 = 1000 * 0.055/ 2 = 1000 * 0.0275 = $27.5 is the coupon payment
Current bond price = $1,000 par value * 102% of par = $1,020

Now, let us calculate the yield to maturity:
Formula for yield to maturity = {coupon payment + (par value - current price) / N} / (par value + current price) / 2

= {27.5 + (1,000 - 1,020) / 22} / (1,000 + 1,020) / 2 = 2.67%

Yield to maturity (YTM) = 2.67% * 2 = 5.34%
Before tax cost of debt = 5.34%
The company’s tax rate = 33%
After tax cost of debt = 5.34% * (1-0.33)= 5.34% * (0.67)= 3.58%
The after tax cost debt is 3.58%

Now, let us find the cost of equity:

Cost of equity = risk free rate + beta ( market risk premium)

= 0.045 + 1.19 * (0.07)

=0.045 + 0.0833 = 0.1283

= 12.83% is the Cost of equity

The cost of preference stock = face value * interest rate / current selling price

= 100 * 4.5% / 103 = 4.5 / 103 = 0.0436 = 4.4% is the cost of preference stock.

Formula for WACC (Weighted average cost of capital)
= We * Cost of equity + Wd * After tax cost of debt + Wp * cost of preference stock

Here, we know Cost of equity, After tax cost of debt and cost of preference stock
We need to find We (weight of equity), Wd (weight of debt) and Wp (weight of preference stock).

The total market value of equity = $4,620,000 (i.e, 84,000 shares * $55)
Total market value of debt = $3,570,000 (i.e, $1,020 *3,500)
Total market value of preference stock = $1,030,000 (i.e, 10,000 shares * $103)
Total value of the firm = $4,620,000 + $3,570,000 + $1,030,000 = $9,220,000

We (weight of equity) = $4,620,000 /  $9,220,000 = 0.50
Wd (weight of debt) = $3,570,000 /  $9,220,000 = 0.39
Wp (weight of preference stock) = $1,030,000 /  $9,220,000 = 0.11

Therefore, WACC = We * Cost of equity + Wd * After tax cost of debt + Wp * cost of preference stock

= 0.50 * 12.83% + 0.39 * 3.58% + 0.11 * 4.4%

= 0.006415 + 0.01396 + 0.00484

= 0.0829 = 8.3% is the WACC

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