Millier\'s is determining its cost of capital prior to expanding its business. T
ID: 2720290 • Letter: M
Question
Millier's is determining its cost of capital prior to expanding its business. The firm has a targeted capital structure of 40% debt, 15% preferred stock, and the balance in common stock. The firm has provided you with the following information to help determine the WACC. The frim has bonds with a 6.6% coupon paid semiannually and 5 years to maturity. These bonds currently sell for $890 each. The tax rate is 40%. What is the cost of debt financing and component cost of debt. Preferred stock is selling for $35 per share and has a dividend of 9.5% on the par value of $10 per share. What is the component cost of debt? Beta for the firm is 1.5. The firms risk free rate is 6%. The market risk premium is 5% and the risk free rate is 4%. The firm will pay a dividend of $.98 on stock that sells for $7.20 per share. Dividend growth is estimated at 3%. Flotation costs are 20 cents per share. Find the cost of equity using the methods indicated by the data. What is the WACC? Show all steps and formulas.
Explanation / Answer
Answer:
A. Cost of Debt (Bond) (Kd)
Maturity tenure = 5 Years
Current Maket Price of BOnd = $890
Face Value of Bond (Assumed) $1,000
Interest Payment = Semi-Annualty, therefore the interest rate = 6.6% / 2 =3.3%
Interest Amount per bond = 3.3% x $1,000 = $33
No. of times interest paid = 5 x 2 = 10
These are redeemable Bond and the cost of redeemable bond is calculated by using following formula
Cost of Bond = [ Interest (1 - tax) + (Redemption Value - Net Proceeds)/life ] / (Redemption Value + Net Proceeds)/2
Cost of Bond = [ $33 (1 - 0.40) + ($1,000 - $890)/10 ] / ($1,000 + $890)/2 = ($19.80 + $11) / $945 = 0.03259 or 3.259% semi-annualy or 6.518% annually
B. Cost of Preferred Stock (Kp)
Cost of Preferred Stock = Preference Dividend / Current Market Price x 100 = $9.5 / $35 = 27.143%
C. Cost of Equity (Ke)
As per the information given in the question, Cost of equity is calculated by both of following formula given as under:
(i) As per CAPM model, Cost of Equity = Risk Free Rate + Beta of firm x Market Premium = 6% + 1.50 x 5% = 13.50%
(ii) As per Dividend Growth Model, Cost of Equity = Next Year dividend / Net Proceed - Flotation Cost + Growth
= $0.98 / ($7.20 - $0.20) + 0.03 = 17%
D. Calculation of WACC (by taking Cost of Equity as per CAPM Model)
WACC = (KexWe) + (KdxWd) + (KpxWp)
here W means Weight
WACC = (13.50 x 0.45) + (6.518 x 0.40) + (27.143 x 0.15) = 6.075 + 2.6072 + 4.07145 = 12.75%
E. Calculation of WACC (by taking Cost of Equity as per Dividend Growth Model)
WACC = (KexWe) + (KdxWd) + (KpxWp)
here W means Weight
WACC = (17 x 0.45) + (6.518 x 0.40) + (27.143 x 0.15) = 7.65 + 2.6072 + 4.07145 = 14.328 or 14.33%