Problem 12-18 Calculating the WACC [LO 3] You are given the following informatio
ID: 2725544 • Letter: P
Question
Problem 12-18 Calculating the WACC [LO 3] You are given the following information concerning Parrothead Enterprises: Debt: 10,300 7.3 percent coupon bonds outstanding, with 22 years to maturity and a quoted price of 107.25. These bonds pay interest semiannually. Common stock: 290,000 shares of common stock selling for $65.80 per share. The stock has a beta of .98 and will pay a dividend of $4.00 next year. The dividend is expected to grow by 5.3 percent per year indefinitely. Preferred stock: 9,300 shares of 4.65 percent preferred stock selling at $95.30 per share. Market: A 10.7 percent expected return, a risk-free rate of 5.3 percent, and a 38 percent tax rate. Required: Calculate the WACC for Parrothead Enterprises. (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).) WACC %
Explanation / Answer
Total Value of Debt = $107.25 x 10,300 = $1,104,675
Total Value of Equity = $65.80 x 290,000 = $19,082,000
Total Value of Preferred Stock = $95.30 x 9,300 = $886,290
Total Capital = $1,104,675 + $19,082,000 + $886,290 = $21,072,965
Weight of debt = $1,104,675/$21,072,965 = 0.05242
Weight of equity = $19,082,000/$21,072,965 = 0.9055
Weight of preferred stock = $886,290/$21,072,965 = 0.04205
Cost of debt is the after-tax YTM of the bond:
YTM:
Bond Value = C/2 {[1-(1+(YTM/2))-2t/(YTM/2)] + [F / (1+ (YTM/2))2t]
B0 = $107.25
C = $100 x 7.3% = $7.3
F = $100 (As current price is $107.25, it needs to be $100)
YTM = the yield to maturity on the bond, (also known as discount rate)
t = 22
$107.25 = $7.3/2 {[1-(1+(YTM/2))-44/(YTM/2)] + [$100 / (1+ (YTM/2))44] = 6.67%
After-tax YTM = YTM x (1-tax rate) => 6.67% x 62% = 4.1354%
Cost of Equity is the required rate of return as per CAPM model:
E(R) = Rf + Beta*(Rm – Rf)
=> 5.3% + 0.98*(10.7% - 5.3%) = 10.592%
Cost of preferred stock is simply percentage paid. So, here, it’s 4.65%
WACC = (Wd x rd) + (We x Ke) + (Wp x Kp)
=> (0.05242 x 0.041354) + (0.9055 x 0.10592) + (0.04205 x 0.0465) = 0.10 or 10%
(Note: Following the general procedure to calculate WACC, we have calculated the WACC. However, as the question also talks about expected dividend and growth rate, it may be possible that they want you to calculate cost of equity using dividend growth model. If it’s the case, please use the cost of equity calculated below for WACC calculation.
Price of stock = expected dividend / (Cost of equity – growth rate)
$65.80 = $4 / (Ke – 0.053)
Ke = 0.11379 or 11.379% )