The Imaginary Products Co. currently has debt with a market value of $300 millio

Question

The Imaginary Products Co. currently has debt with a market value of $300 million outstanding. The debt consists of 9 percent coupon bonds (semiannual coupon payments) which have a maturity of 15 years and are currently priced at $839.36 per bond. The firm also has an issue of 2 million preferred shares outstanding with a market price of $21. The preferred shares pay an annual dividend of $1.20. Imaginary also has 14 million shares of common stock outstanding with a price of $20.00 per share. The firm is expected to pay a $2.20 common dividend one year from today, and that dividend is expected to increase by 8 percent per year forever. If Imaginary is subject to a 40 percent marginal tax rate, then what is the firm’s weighted average cost of capital?

the Weights for debt, common equity, and preferred equity.

Calculate the cost of debt. (Round intermediate calculations to 4 decimal places, e.g. 1.2514 and final answer to 2 decimal places, e.g. 15.25%.)

Explanation / Answer

Cost of debt is computed using the YTM approach.

YTM = [C + (F - P) / N] / [(F + P) / 2] where

F: Face value = $1,000,

P: Market price = $839.36

N: Years to maturity = 15

C: Coupon payment (annual) = $1,000 x 9% = $90

YTM = [90 + (1,000 - 839.36) / 15] / [(1,000 + 839.36) / 2]

= [90 + 10.71] / 919.68 = 100.71 / 919.68 = 0.1095

Bond YTM is pre-tax cost of debt. So, Post-tax cost of debt:

kd = YTM x (1 - tax rate) = 10.95% x (1 - 0.4) = 10.95% x 0.6 = 0.0657

kd = 6.57%

Cost of equity, ke = (D1 / P0) + g = $(2.2 / 20) + 0.08

= 0.11 + 0.08

= 0.19, or 19%

Cost of preferred stock, kp = Annual dividend / Share market price

= $1.2 / $21 = 0.0571

kp = 5.71%

WACC = (48.23% x 6.57%) + (6.75% x 5.71%) + (45.02% x 19%)

= 3.17% + 0.39% + 8.55%

= 12.11%

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