Question

XYZ Company is considering a new project which has the same risk level as its current business. The new project has an initial cash outlay of $40,000 and projected cash inflows of $15,000 in year one, $10,000 in year two, and $10,000 in year three. XYZ Corporation has 16 million shares of common stocks, 1.2 million shares of preferred stocks and 0.3 million units of bonds outstanding. The bond has 2 years to maturity. Each bond sells for $1,000 (same as its face value) per unit and pays coupons at 6 percent annually. The common stock currently sells for $40 per share and has a beta of 1.5. The preferred stock sells for $50 and pays $5 dividend per share. The market risk premium is 10 percent and the risk-free rate is 5 percent. The corporation tax rate is 20 percent.

What is the WACC of XYZ Company?

Answer 1

The cost of equity is :

Re = Rf + beta * (Rm - Rf)

= 5 + 1.5* (10)

= 20%

The cost of preferred stock is :

= Preferred dividend/ price of preference share

= $5/ $50

= 10%

The YTM of bond is :

FV = $1000

PV = ($1000)

N = 2 Years

PMT = $60

I/Y = 6%

The market value of bonds is : $1000 * 0.3 million

= $300 million

The market value of common stock is : 16 million * $40

= $640 million

The market value of preference equity is : 1.2 million * $50

= $60 million

So, the weights are :

Debt = $300/ $1000

= 0.3

Equity is = 0.64

Preference = 0.06

So, the WACC is :

= 0.3*0.06* 0.8 + 0.64*0.2 + 0.06*0.1

= 0.0144 + 0.128 + 0.006

= 14.84%

So, the WACC is 14.84%