Question

Assume the current dividend payment for Franklin Inc. is $5/share, and it will grow at the constant rate of 9% per year. The required rate of return for the Franklin Inc. is 15%.

Now with

-Current corporate Tax Rate is 40%.

-Franklin Inc. has 15-year, 12% coupon, semiannual payment, non-callable bonds sell for $1,150, future value is $1,000.

-Beta = 1.2; Risk-free rate = 7%; Market risk premium = 6%

-Management has determined the target capital structure for the company is: 40% debt, 60% common equity

a)What is the company’s cost of debt? (5%)

b)What is the company’s cost of common equity? (5%)

c)What is the company’s weighted average cost of capital (WACC)? (10%)

Answer 1

Answer a.

Face Value = $1,000
Current Price = $1,150

Annual Coupon Rate = 12%
Semiannual Coupon Rate = 6%
Semiannual Coupon = 6% * $1,000
Semiannual Coupon = $60

Time to Maturity = 15 years
Semiannual Period to Maturity = 30

Let semiannual YTM be i%

$1,150 = $60 * PVIFA(i%, 30) + $1,000 * PVIF(i%, 30)

Using financial calculator:
N = 30
PV = -1150
PMT = 60
FV = 1000

I = 5.02%

Semiannual YTM = 5.02%
Annual YTM = 2 * 5.02%
Annual YTM = 10.04%

Before-tax Cost of Debt = 10.04%
After-tax Cost of Debt = 10.04% * (1 - 0.40)
After-tax Cost of Debt = 6.02%

Answer b.

Cost of Equity using CAPM:

Cost of Equity = Risk-free Rate + Beta * Market Risk Premium
Cost of Equity = 7% + 1.2 * 6%
Cost of Equity = 14.20%

Answer c.

WACC = Weight of Debt * After-tax Cost of Debt + Weight of Equity * Cost of Equity
WACC = 40% * 6.02% + 60% * 14.20%
WACC = 10.93%