• ACE’s stock has a current market price of $52.25 a share and the company expec

Question

• ACE’s stock has a current market price of $52.25 a share and the company expects to pay a dividend next year of $3 per share. • Dividends have been growing at a constant rate of 5% a year and are expected to continue that pattern. • The company also has a small amount of preferred stock outstanding that currently sells for $107 per share and pays an 8% of par value ($100) dividend. • ACE also has one bond issue outstanding that has a 7% coupon rate and pays interest annually. • Those $1,000 par value bonds currently have 9 years remaining to maturity and are selling for $941 each. • The total market value of the company’s common stock is $45 million, preferred stock $6 million, and debt is $33 million. • ACE’s marginal tax rate is 15%.

Calculate ACE's WACC. ACE is considering investing in a project and can borrow money at 5%.

What discount rate should ACE use and why?

How would your answer change if the company did not expect dividends to increase in the future?

How would your answer change if the company's bonds paid semi-annual interest payments?

Explanation / Answer

Part A)

WACC can be calculated with the use of following formula:

WACC = After-Tax Cost of Debt*Weight of Debt + Cost of Preferred Stock*Weight of Preferred Stock + Cost of Equity*Weight of Equity

Where Weight of Debt = Market Value of Debt/(Market Value of Debt + Market Value of Preferred Stock + Market Value of Equity)

Weight of Preferred Stock = Market Value of Preferred Stock/(Market Value of Debt + Market Value of Preferred Stock + Market Value of Equity)

Weight of Equity = Market Value of Equity/(Market Value of Debt + Market Value of Preferred Stock + Market Value of Equity)

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Step 1: Calculate Cost of Equity

The cost of equity can be calculated as follows:

Cost of Equity = Expected Dividend/Current Share Price + Growth Rate = 3/52.25 + 5% = 10.74%

____________

Step 2: Calculate After-Tax Cost of Debt

The cost of debt can be calculated with the use of Rate function/formula for EXCEL/Financial Calculator. The function/formula for Rate is Rate(Nper,PMT,-PV,FV) where Nper = Period, PMT = Interest Payment, PV = Present Value and FV = Face Value

____________

Here, Nper = 9, PMT = 1,000*7% = $70, PV = $941 and FV = $1,000

Pre-Tax Cost of Debt (Rate) = Rate(9,70,-941,1000) = 7.94%

After-Tax Cost of Debt = Pre-Tax Cost of Debt*(1-Tax Rate) = 7.94%*(1-15%) = 6.75%

____________

Step 3: Calculate Cost of Preferred Stock

The cost of preferred stock can be calculated as follows:

Cost of Preferred Stock = Annual Dividend/Current Stock Price*100 = (8%*100)/107*100 = 7.48%

____________

Step 4: Calculate WACC

WACC = 6.75%*33/(33 + 6 + 45) + 7.48%*6/(33 + 6 + 45) + 10.74%*45/(33 + 6 + 45) = 8.94%

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Part B)

The company should use the WACC as the discount rate. It is so because, the overall cost of capital comprises of all the financial instruments (equity, preferred stock and debt).

____________

Part C)

To determine the change, we need to calculate the revised cost of equity without the growth rate. The revised cost of equity would be:

Revised Cost of Equity = 3/52.25 + 0 = 5.74%

Revised WACC has been calculated as follows:

Revised WACC = 6.75%*33/(33 + 6 + 45) + 7.48%*6/(33 + 6 + 45) + 5.74%*45/(33 + 6 + 45) = 6.26%

The weighted average cost of capital would come down to 6.26% from 8.94%.

____________

Part D)

To determine the change, we need to calculate the revised cost of debt with semi-annual interest payments. The revised cost of debt would be:

Here, Nper = 9*2 = 18, PMT = 1,000*7% = $70/2 = $35, PV = $941 and FV = $1,000

Pre-Tax Cost of Debt (Rate) = Rate(18,35,-941,1000)*2 = 7.93%

After-Tax Cost of Debt = Pre-Tax Cost of Debt*(1-Tax Rate) = 7.93%*(1-15%) = 6.74%

Revised WACC = 6.74%*33/(33 + 6 + 45) + 7.48%*6/(33 + 6 + 45) + 10.74%*45/(33 + 6 + 45) = 8.94%

There is no change in the WACC. It continues to be 8.94%

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