Meacham Corporation wants to issue bonds with a 9% coupon rate, a face value of
ID: 2751811 • Letter: M
Question
Meacham Corporation wants to issue bonds with a 9% coupon rate, a face value of $1,000, and 12 years to maturity. Meacham estimates that the bonds will sell for $1,090 with issuing (flotation) costs equal $15 per bond—this reflects an 8% before tax cost of debt on the bonds. Meacham’s preferred stock currently sells for a price of $30 per share, and their dividend payment is 8% on these $100 par value preferred stocks. Meacham's common stock has a beta of 1.4. The risk free rate of return associated with their common stocks is 4%. The average return of the market as a whole for common stock is 10%. Meacham's marginal tax rate is 35%. Meacham's capital structure is 40% debt, 50% common equity, and 10% preferred stock.
a. Calculate the after-tax cost of debt assuming Meacham's bonds are its only debt.
b. Calculate the cost of preferred stock.
c. Calculate the cost of common stock/equity.
d. Calculate the weighted average cost of capital for Meacham's $30 million capital budget.
Explanation / Answer
a) After tax cost of debt = 8% * (1-35%) =
Debt weight = 40%
b) Cost of preferred stock = 8%
Preferred equity weight = 10%
c) Cost of equity using the CAPM model can be calculated as follows
Cost of Equity = Risk free return + Beta * (Market return - risk free return)
Cost of Equity = 4% + 1.4 * (10% - 4%) = 12.4%
Equity weight = 50%
d) WACC can be calculated as follows
WACC = Sum of (Security weight * Security return)
WACC = 50% * 12.4% + 40% * 5.2% + 10% * 8% = 9.08%