Question

Chelsea’s rentals recently hired you as a consultant to estimate the company’s WACC. You have obtained the following information. (1) The firm's noncallable bonds mature in 15 years, have an 7.50% annual coupon, a par value of $1,000, and a market price of $1,075.00. (2) The company’s tax rate is 40%. (3) The risk-free rate is 2.50%, the market risk premium is 6.50%, and the stock’s beta is 1.30. (4) The target capital structure consists of 35% debt, 10% preferred stock, and the balance is common equity. (5) The preferred stock currently trades at $50 and has a dividend of $4 per share.

1. What is the cost of debt?

1. 11%           b. 6.69%         c. 7.6%           d. 12.05%

2. What is the cost of preferred stock?

1. 9.27%        b. 10.95%       c. 8.00%         d. 7.05%

3. What is the cost of equity? (use CAPM model to compute)

1.    13.67%      b. 10.95%       c. 17.64%       d. 12.05%

4. What is the WACC?

1. 8.23%        b. 10.95%       c. 9.00%         d. 6.75%

5. Assume that the risk-free rate is 3.5% and the expected return on the market is 9%.

      What is the required rate of return on a stock with a beta of 1.2? (CAPM model)

            a. 9.55%         b. 10.1%         c. 13.6%         d. 6.05%

Answer 1

Solution :- (1)

Annual Coupon = $1,000 * 7.5% = $75

Therefore Cost of Debt = 6.69%

( 2 ) Cost of Preferred Stock = Dividend / Stock Price = $4 / $50 = 8%

Therefore Correct Answer is (C)

(3) Cost of Equity = Rf + Beta ( Risk Premium )  

= 2.5% + 1.30 * ( 6.5% )

= 10.95%

Therefore Correct answer is (b)

(4) WACC = [ Wd * Kd * ( 1 - tax ) ] + [ Wp * Kp ] + [ We * Ke ]

= [ 35% * 6.69% * ( 1 - 0.40 ) ] + [ 10% * 8% ] + [ 55% * 10.95% ]

= 1.405% + 0.8% + 6.0225%

= 8.23%

Therefore Correct Answer is (A)

(5 ) If Beta 1.2

Cost of Equity = Rf + Beta ( Rm - Rf  )  

= 3.5% + 1.20 * ( 9.0% - 3.5% )

= 10.1%

Therefore Correct Answer is (B)

If there is any doubt please ask in comments

Thank you please rate