Question

Vandelay Industries is considering four average risk projects with information below

related to their rates of return. Determine Vandelay Industries' WACC.

INPUTS USED IN THE MODEL

Tax rate 30%

B-T rd 8%

Net Pps $35.00

Dps $5.00

P0 $50.00

D1 $2.50

g 5%

Vandelay's beta 1.1

Market risk premium, RPM 7.50%

Risk free rate, rRF 3.0%

Target capital structure from common stock 60%

Target capital structure from preferred stock 15%

Target capital structure from debt 25%

Calculate the cost of each capital component, that is, the after-tax cost of debt, the cost of preferred stock (including flotation costs), and the cost of equity (ignoring flotation costs). Use both the the CAPM method and the dividend growth approach to find the cost of equity.

Cost of debt:

B-T rd ×

(1 – T) = A-T rd

Cost of preferred stock (including flotation costs):

Dpf /

Net Ppf = rpf

Cost of common equity, dividend growth approach (ignoring flotation costs):

D1 /

P0 +

g =

rs

Cost of common equity, CAPM:

rRF + b × RPM = rs

Vandelay Industries will continue to use the same capital structure, what is the company's WACC?

wd 25.0%

wps 15.0%

ws 60.0%

100.0%

wd × A-T rd +

wpf × rpf +

ws × rs   

= WACC

Answer 1

cost of debt (after tax) = B - T rd*(1 - t)

= 8%*(1 - 0.3)

= 5.6%

cost of preferred stock: = Dpf / Net Ppf

= 5 / 35

= 14.29%

cost of common equity = (D1 / P0) + g

= (2.5 / 50) + 5%

= 10%

Cost of common equity (CAPM) :

= 3% + 1.1(7.5%)

= 11.25%

WACC:

using the formula given above,

WACC = (0.25* 5.6) + (0.15 * 14.29) + (0.6*10)

= 1.4 + 2.14 + 6

= 9.54%

(NOTE : for calculating WACC cost of equity calculated under dividend discount model taken.if CAPM cost of equity taken answer would be different. please consider)