M2M Company has 500,000 shares of common stock outstanding at a market price of
ID: 2818784 • Letter: M
Question
M2M Company has 500,000 shares of common stock outstanding at a market price of $40 a share. Last month, M2M paid an annual dividend in the amount of $1.20 per share. The dividend growth rate is 6%. M2M also has 20,000 bonds outstanding with a face value of $1,000 per bond. The bonds carry a 6% coupon, pay interest annually, and mature in 10 years. The bonds are selling at 101% of face value. The company's tax rate is 25%. What is M2M's weighted average cost of capital? 7.36% 6.97% 6.78% 6.23% 5.94%
Explanation / Answer
Market value of common stock = 500,000 * 40 = $20,000,000
Market value of bonds = 20,000 * ( 1,000 * 101%) = $20,200,000
Total market value = 20,000,000 + 20,200,000 = 40,200,000
Cost of equity = (D1 / share price) + growth rate
Cost of equity = [ ( 1.2 * 1.06) / 40] + 0.06
Cost of equity = 0.0318 + 0.06
Cost of equity = 0.0918 or 9.18%
Coupon payment = 0.06 * 1000 = 60
Price = 1.01 * 1000 = 1,010
Before tax cost of debt using a financial calculator = 5.865%
Keys to use in a financial calculator: FV 1000, PV -1010, N 10, PMT 60, CPT I/Y
Weighted average cost of capital = Weigth of debt * after tax cost of debt + weight of equity * cost of equity
Weighted average cost of capital = ( 20,200,000 / 40,200,000) * 0.05865 * ( 1 - 0.25) + ( 20,000,000 / 40,200,000) * 0.0918
Weighted average cost of capital = 0.022103 + 0.045672
Weighted average cost of capital = 0.0678 or 6.78%
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