Question

Wisdom Institute of Education is a reputed public company and wishes to estimate its cost of capital. The company’s current capital structure, in terms of market value, includes 30% debt, 20% preferred equity, and 50% ordinary shares. The company’s debt has an average yield to maturity of 8.3%. Its preferred shares have a $70 par value, an 8% dividend, and are currently selling for $76 per share. Wisdom beta is 1.5, the risk-free rate is 4.5%, and the market rate is 11.4%. The company is in the 30% tax bracket.

a)       Calculate the after-tax costs of debt and ordinary shares of the company.

b)      Calculate Wisdom’s weighted average cost of capital (WACC) on both a pre-tax and after-tax basis.

c)       Which WACC should Wisdom use when making investment decisions? Justify your answer

Answer 1

After tax cost of debt = Yield to maturity*(1-Tax rate)

= 8.3%*(1-30%)

= 5.81%

Cost of preferred stock = Annual dividend/Current Selling price

= 70*8%/76

= 7.37%

Cost of Equity as per CAPM = risk free rate + beta*(Market rate – risk free rate)

= 4.5% + 1.5*(11.4%-4.5%)

= 14.85%

WACC = Cost of debt*weight of debt + cost of preferred stock *weight of preferred stock + Cost of Equity*weight of equity

Before tax WACC = 8.3%*30% + 7.37%*20% + 14.85%*50%

= 11.389%

i.e. 11.39%

After tax = 5.81%*30% + 7.37%*20% + 14.85%*50%

= 10.642%

i.e. 10.64%

c)After tax should be used as interest payments are tax deductible and hence, after tax cost on debt is relevant