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?

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

2. What is the cost of preferred stock?

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

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

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

4. What is the WACC?

- 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)

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