Question

Estimating WACC

Dilworth Corp’s balance sheet reflects long-term debt amounting to $800 million. This debt consists of 7% coupon bonds that have 15 years remaining until maturity. The bonds are currently trading for $920 per $1000 face value. The company also has preferred stock outstanding that makes a fixed quarterly dividend payment of $3.50 in perpetuity. The book value of this preferred stock is $180 million, and the par value of each share is $100. Each share of preferred is currently trading for $120. Dilworth has 25 million shares of common stock outstanding, and the current price per share is $48

Investors require a premium of 5.5% over bond yield as inducement to invest in Dilworth common shares. Dilworth’s equity beta is 1.40. The estimated required return on the market portfolio is 10%, and the yield on 10-year Treasuries (proxy for the risk-free rate) is 3%. Dilworth is in steady-state growth (in earnings and dividends). Its per-share annual dividends have increased from $3.00 to $4.00 in the last 8 years, and analysts expect this rate of growth to continue in the foreseeable future. The $4.00 per-share dividend has just been paid out.

Dilworth Corp faces a marginal tax rate of 30%.

Estimate its weighted average cost of capital.

I know the answer is 10.23%, but I cannot get my calculations to come out correctly.

Answer 1

First of all lets calculate cost of debt

Current market value =CMV = 920, coupon rate is 7%, face value =FV = 1000$, n = 15

YTM = Interest + (FV-CMV/n)/ (FV+CMV/2)

=1000*7% + (1000-920/15) / (1000+920/2)

=70 + 5.333 / 960

=7.85%

After tax cost of debt = 7.85%(1-tax rate)

=7.85%(1-0.3)

=7.85%(0.7)

=5.49%

Cost of preference shares = Dividend/CMP

=3.5*4/120

=14/120

=11.67%

Cost of equity shares = Rf+b(Rm-Rf)

=3%+1.4(10%-3%)

=3%+1.4(7%)

=3%+9.8%

=12.8%

Statement showing WACC

Source of capital	Amount		Weight	K	WACC
Equity	25 *48	1200	55.8%	12.80%	7.1%
Debt	800/1000*920	736	34.2%	5.49%	1.9%
Pref shares	180/100*120	216	10.0%	11.67%	1.2%
		2152			10.2%