Question

A firm has 75,000 bonds outstanding that are selling at par. Bonds with similar characteristics are yielding 7.50% (market rate). The company also has 750,000 shares of 6% preferred stock and 2.5 million shares of common stock outstanding. The preferred stock sells for $64 per share. The common stock has a beta of 1.21 and sells for $44 per share. The U.S. Treasury bill is yielding 2.30% (market rate) and the return on the market is 11.20%. The corporate tax rate is 34%. What is the firm's weighted average cost of capital?

a. 10.64%

b. 9.69%

c. 11.56%

d. 11.30%

e. 11.18%

Answer 1

Total value of debt = 75000*1000 = 75000000

Cost of debt = 7.5%

Total value of preferred stock = 750000*64 = 48000000

Cost of preferred stock = Annual dividend/price = 6/64 = 9.38%

Total value of common stock = 2500000*44 = 110000000

Cost of common stock = Risk free rate + beta*(Market return - risk free rate) = 2.3% + 1.21*(11.2-2.3) = 13.07%

Total value = 75000000 + 48000000 + 110000000 = 233000000

WACC = rD (1- Tc )*( D / V )+ rE *( E / V )

Where...

rD = The required return of the firm's Debt financing
(1-Tc) = The Tax adjustment for interest expense
(D/V) = (Debt/Total Value)
rE= the firm's cost of equity
(E/V) = (Equity/Total Value)

WACC = 75000000/233000000 * 7.5%*(1-0.34) + 48000000/233000000 * 9.38% + 110000000/233000000 * 13.07% = 9.69%

Option b.