Question

You work for an investment banking firm and have been asked by management of Vestor Corporation (not real), a software development company, to calculate its weighted average cost of capital, to use in evaluating a new company investment. The firm is considering a new investment in a warehousing facility, which it believes will generate an internal rate of return of 11.5%. The market value of Vestor's capital structure is as follows: Source of Capital Market Value Bonds $10,000,000 Preferred Stock $2,000,000 Common Stock $8,000,000 To finance the investment, Vestor has issued 20 year bonds with a $1,000 par value, 6% coupon rate and at a market price of $950. Preferred stock paying a $2.50 annual dividend was sold for $25 per share. Common stock of Vestor is currently selling for $50 per share and has a Beta of 1.2. The firm's tax rate is 34%. The expected market return of the S&P 500 is 13% and the 10-Year Treasury note is currently yielding 3.5

Answer 1

Basic calculations

Ke = cost of equity = Risk free rate + Beta * ( Return on market - Risk free rate )

= 3.5 + 1.2 * ( 13 - 3.5) = 14.90 %

Kp = Cost of preferred capital = Dividend per share / Price per share * 100 = 2.5 / 25 * 100 = 10%

Ki = Cost of debt = YTM = 6.45 % .......... ( computed using ytm calculator)

Ki ( after tax ) = 6.45 * ( 1 - 0.34) = 4.257 %

Calculation of WACC

Source	Amount	W	K	K * W
Bonds	10,000,000	0.5	4.257	2.2185
Preferred stock	2,000,000	0.1	10	1
Common stock	8,000,000	0.4	14.9	5.96
Total	20,000,000		WACC	9.09

W = Weight ........ it is computed as individual amount / total amount. example for bonds = 10,000,000 / 20,000,000. = 0.50.

K = cost of capital

K*W is the multiplication of weights with respective cost of capitals.

Finally, the total of K*W shall give the WACC.