Imaginary Products Ltd currently has $300 million of market value debt outstandi
ID: 2810559 • Letter: I
Question
Imaginary Products Ltd currently has $300 million of market value debt outstanding. The 9 per cent coupon bonds (semiannual payment) have a maturity of 15 years and are currently priced at $1,440.03 per bond.
The company also has an issue of 2 million preference shares outstanding with a market price of $12.00.
The preference shares offer an annual dividend of $1.20. Imaginary also has 14 million ordinary shares outstanding with a price of $20.00 per share. The company is expected to pay a $2.20 ordinary dividend one year from today, and that dividend is expected to increase by 5 per cent per year forever.
Required Part If the corporate tax rate is 30 per cent, then what is the company’s weighted average cost of capital?
Explanation / Answer
WACC = [D/V *RD *(1-T)] + [E/V * RE] + [P/V * RP]
Total Debt (D) = $300 Million
-> D = $300,000,000
The YTM of the c bond is equal to the firm's Cost of Debt
YTM of 9% coupon bond with $1,000 Face Value which pays semi annual coupons with a Maturity of 15 Years with a price of $1,440.03 currently can be calculated using the Excel function "RATE(nper, pmt, PV, FV)"
For this bond; pmt = 9%*1000 / 2 (since semi-annual coupons are made i.e 2 coupons in a year)
-> pmt = $45 (Cash Inflow to the buyer)
nper = 15 years * 2 (since semi-annual payments) = 30
PV = -$1,440.03 (Since cash outflow to the buyer) & FV = $1,000 (Cash Inflow to the buyer)
-> YTM = RATE(30,45,-1440.03,1000)
-> YTM = 2.42% SEMI-ANNUAL
-> YTM = 4.84%
Therefore, Cost of debt for the firm (rD)= 4.84%
Total Common Stock/Equity of Watson Power Co. (E) = Shares Outstanding * Price per share
-> E = 14,000,000 * $20
-> E = $280,000,000
Cost of Equity(rE ) = (dividends per share for next year*100 / Current Market Value of equity) + Divdend Growth Rate = Dividend Yield + Dividend Growth Rate
-> rE =($2.20*100/ 20.00) + (5%)
-> rE = 16%
Total Value of Preferred Stock (P) = No.of Outstanding shares preferred stock * Price per share of each preferred stock
-> P = 2,000,000 * $12
-> P = $24,000,000
-> Dividend on preferred stock = $1.20
Dividend Yield on Preferred Stock = Dividend / Price per share of Stock = 1.20/12 = 0.1 = 10%
The cost of capital of Preferred stock is equal to its dividend yield
-> rP = 10%
Total Value of the firm (V) = D+E+P = 300,000,000 + 280,000,000 + 24,000,000
-> V = $604,000,000
D/V = 300,000,000 / 604,000,000 = 0.497
E/V = 280,000,000 / 604,000,000 = 0.464
P/V = 24,000,000 / 604,000,000 = 0.039
rD= 4.84%, rE = 16%, rP = 10%
Given Tax = 30%
WACC = [D/V *RD *(1-T)] + [E/V * RE] + [P/V * RP]
Therefore, WACC = [0.497*4.84%*(1-0.3)] + [0.464*16%] + [0.039*10%]
-> Weighted Average Cost of Capital (WACC) = 9.50%