Question

A firm has $50 million in 10-year debt with a YTM of 9% and a coupon of 10% ang thus selling at premium of $64.18
It also has 200,000 shares of preferred stock with a $4 dividend that sells for $90 a share and common stockwith a book value of $80 million and a par value of $5 a shre that sells for $50 a share.

The common stock pays a dividend of $4 which is expected to grow at 5% rate forever. The firm has a beta of 1.2

A. Given this data find WACC for this firm if the tax rate is 40%. Use the dividend growth model. Then repeat using the CAPM if the expected return on the S&P is 13% and the risk-free rate is 7%

B. Next, assume this firm wants to get into a new industry and has chosen a proxy company with a beta of 1.6 and debt-to-equity ratio of 0.4
Find the WACC for the firm.

Answer 1

a) Using dividend growth model, Cost of equity, re = D / P + g = 4 / 50 + 5% = 13%

	Value	Weight	Cost
Debt	64.18	7.3%	9.00%
Preferred	18	2.0%	4.44%
Equity	800	90.7%	13.00%
Total	882.18	WACC	12.27%

WACC = wd x rd x (1 - tax) + wps x rps + we x re

where, wd - weight of debt = 64.18 / 882.18, wps - weight of preferred = 0.2 x 90 / 882.18, we = (80 / 5 x 50) / 882.18, rd - cost of debt = 9%, tax = 40%, rps = Cost of preferred = 4 / 90,

re - Cost of equity = 13% using dividend growth model => WACC = 12.27%

Using CAPM, re = Rf + beta x (Rm - Rf) = 7% + 1.2 x (13% - 7%) = 14.20%

=> WACC (using CAPM) = 13.36%

b) Unlevered beta = Levered beta / (1 + (1 - tax) x D/E) = 1.6 / (1 + (1 - 40%) x 0.4) = 1.29

Using CAPM, Cost of capital = Rf + beta x (Rm - Rf) = 7% + 1.29 x (13% - 7%) = 14.74%