Question

1. The market value of Aardvark Corp. as of December 31, 2019 was $750 million. The firm’s current capital market structure is on target and is as follows:

Debt:                                      $150 mil

Preferred Stock:                   $50 mil

Common Stock:                   $550 mil

Using data in the Wall St. Journal, the company’s bonds are calculated to have a nominal yield to maturity of 5.5%. The company’s preferred stock sells for $100 per share and pays an annual dividend of $6.25 per share. The company’s common stock sells for $80 per share and is expected to pay a dividend of $10 per share by the end of this year (i.e. Div₁=$10.00). The dividend is expected to grow at a constant rate of 6% a year. The yield on Treasury Bills is 4.9% while the market risk premium is believed to be 8%. Aardvark is an aggressive stock with a Beta of 1.7.The company’s tax rate is 21%.

Compute the market value weights, each component cost of capital and the Weighted Average Cost of Capital (WACC) to two decimal places,

Answer 1

4.The cost of each component of capital is :

The cost of debt is : 5.5%

The cost of preferred stock is : $6.25 / $100

= 6.25%

The cost of equity is :
Re = Rf + beta* (Rm - Rf)

= 4.5 + 8*1.7

= 18.5%

The market value weights is :

Debt is : $150/ $750

= 20%

Weight of preferred stock : $50/ $750

= 6.67%

Weight of common stock :

= $550/ $750

=73.33%

So, the WACC is :

= 0.7333 * 0.185 + 0.0667*0.0625 + 0.2* 0.055

= 0.1357 + 0.0042 + 0.011

= 15.09%

So, the WACC is 15.09%.(rounded off to two decimal places)