Question

Ms. R. Pavone, the financial manager at Carelli Corporation(CC), is planning to estimate the WACC for the company. The company currently has 20-year annual bonds outstanding. The bonds have an 8.5 percent annual coupon, a face value of $1,000, and they currently sell for $945. The company’s beta is 1.20, the return on market portfolio is 11 percent, and risk-free rate is 6 percent. The company has outstanding preferred stock that pays a $2.00 annual dividend. The preferred stock sells for $25 a share. The CC’s target capital structure consists of 40 percent long-term debt, 40 percent common stock, and 20 percent preferred stock.Ms. R. Pavone, the financial manager at Carelli Corporation(CC), is planning to estimate the WACC for the company. The company currently has 20-year annual bonds outstanding. The bonds have an 8.5 percent annual coupon, a face value of $1,000, and they currently sell for $945. The company’s beta is 1.20, the return on market portfolio is 11 percent, and risk-free rate is 6 percent. The company has outstanding preferred stock that pays a $2.00 annual dividend. The preferred stock sells for $25 a share. The CC’s target capital structure consists of 40 percent long-term debt, 40 percent common stock, and 20 percent preferred stock.

1) Solve and show steps for WACC.

Answer 1

Cost of debt is given by Yield to maturity

Price of bond = Coupon/(1+YTM)+Coupon/(1+YTM)^2+................+Coupon/(1+YTM)^19+(Face+Coupon)/(1+YTM)^20

945 = 85/(1+YTM)+85/(1+YTM)^2+85/(1+YTM)^3+...............+85/(1+YTM)^19+1085/(1+YTM)^20

On solving, YTM = 9.11%

Cost of preferred stock = Dividend/Market price = 2/25= 8%

Cost of equity = riskfree rate + Beta*Market premium = 6%+1.2*(11%-5%) = 13.20%

WACC = Share of Debt*cost of debt*(1-Tax rate) + Share of Preferred stock*cost of preferred stock + Share of common equity*cost of common equity

Since tax rate is not given we will assume it to be 0%.

WACC = 40%*9.11% + 20%*8% + 40%*13.2% = 10.524%