Mikey s Machines is trying to decide whether or not to invest in a new line of b
ID: 2722080 • Letter: M
Question
Mikey s Machines is trying to decide whether or not to invest in a new line of business renting equipment and wants to calculate their WACC. Assume that their capital structure consists of 35% common stock, 10% preferred stock, and 55% debt. Further, analysts predict that their future cost of debt will be 6% and their cost of preferred stock is 10%. We also know that the current price of common stock is $26 and that the common stock is expected to pay a $2.00 dividend and then continue to grow at a rate of 5%. The firm s tax rate is 35%. What is this firm s WACC?
A. 7.59%
B. 8.74%
C. 4.90%
D. 7.72%
E. None of these
Explanation / Answer
Solution:
Correct Answer is A. 7.59%
WACC of the firm = (Cost of Equity x Weight of Equity in capital structure) + (Cost of Debt after tax x Weight of Debt) + (Cost of Preferred Stock x Weight of Preferred Stock)
Cost of Equity = Expected Dividend / Current Stock PRice + growth rate
= $2 / $26 + 0.05
= 0.0769 + 0.05
= 0.1269 or 12.70%
Cost of Preferred Stock (given) = 10%
After tax cost of debt = Cost of debt before tax x (1 - tax rate)
= 6% (1 - 0.35)
= 3.9%
WACC of the firm = (12.70% x 0.35) + (10% x 0.1) + (3.9% x 0.55)
= 4.445% + 1% + 2.145%
= 7.59%