Weighted Average Cost of Capital Question: Calculate the WACC for Zee Corp. Zee\

Question

Weighted Average Cost of Capital Question: Calculate the WACC for Zee Corp. Zee's has primarily long-term debt, currently trading at 950.25/bond. The 8% coupon, 25 year bonds have l2 years left to maturity. Zee's preferred annual dividend is $2.55, and its preferred stock is currently trading at $32.00/share, 8,000 shares outstanding. Zee just paid common dividend of $1.66/share and is growing at a constant rate of 8.5% annually. Zee's stock is priced at $23.50/share. and it has 35,000 shares of common stock outstanding. Zee's total capital is $1.6 million and it is in the 32% marginal tax bracket.

Explanation / Answer

Formula for the calculation of weighted average cost of capital (WACC) is

WACC = [E/ (E+D+P)]* re + [D/ (E+D+P)] * (1-t) * rd + [P/ (E+D+P)] * rp ……………………………. (1)

Where, re is the cost of equity

And rd is the cost of debt

And rp is the cost of preferred stock

E is the value of common equity = number of common stocks * current market price = 35,000 * $23.50

= $822,500

P is the value of preferred stock = number of preferred stocks * current market price = 8,000 * $32

= $256,000          

D is the value of debt = Zee’s total capital - value of common equity - value of preferred stock

= $1,600,000 - $822,500 - $256,000 = $521,500

And t is the applicable tax rate = 32%

The total value of Zee Corp. = E +D + P = $822,500 + $521,500 + $256,000 = $1,600,000

Required rate of return or Cost of common equity, we can calculate with the following formula

Stock Price P = D1 / (k – g)

Where:

P = the current stock price = $ 23.50

D1 = dividend for next year = $1.66 per share

Required rate of return = re=?

g = growth rate of dividends = 8.5% = 0.085

Therefore

$23.50 = $1.66 / (re – 0.085)

Or   re – 0.085 = $1.66 / $23.5 = 0.0706

Or   re = 0.0706 + 0.085 = 0.1556 =15.56%

Required rate of return or Cost of common equity is 15.56%

Cost of preferred stock rp = Preferred dividend / preferred stock price

= $ 2.55/ $ 32 = 0.0797 = 7.97%

The appropriate cost of debt     

The cost of debt is bond’s yield; we have following formula for calculation of bond’s yield

Bond price P0 = C* [1- 1/ (1+i) ^n] /i + M / (1+i) ^n

Where

Price of the bond P0 = $950.25

C = coupon payment = 8% of $1,000 = $80 per year

n = number of payments or time left to maturity = 12

i = interest rate, or yield to maturity =?

M = value at maturity, or par value = $ 1,000

Now we have,

$950.25 = $80 * [1 – 1 / (1+i) ^12] /i + 1,000 / (1+i) ^12

By trial and error method we got the value of i = 8.68%

Therefore rd = 8.68% (before tax cost of debt)

Now putting the values in equation (1); we get WACC

WACC = ($822,500/ $1,600,000) * 15.56% + ($521,500 / $1,600,000) * (1-32%) * 8.68%+ ($256,000/ $1,600,000) * 7.97%

WACC =8.00% + 1.92% + 1.275%

WACC = 11.20%

Therefore WACC of Zee Corp. is 11.20%

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