Question

The capital structure of company KL is given below:

         Sources of capital    Book value ($ 000)     

         L.T.Debts                         60,000              

         Preferred stock               10,000             

         Common stock                20,000          

         Reserves(re)                    40,000          

         Total capital                   130,000         

The interest rate charged to the long term debt is 10%. Face value of company’s common stock is $1 per share and currently are trading for $8 and dividend for common stock is $1.2 per share. Price of preferred stock is $10 per share and dividend for preferred stock is $1.5 respectively. Assume that the expected growth rate is 5%, average income tax ratio is 30% and corporate tax ratio is 25% . Calculate and comment the WACC of the firm.

Answer 1

We will use the dividend growth formula to calculate the cost of equity and preffered equity.

Price = Div x (1+g)/(r-g)

So, for equity cost of capital,

8 = 1.2 x 1.05/(Re - 0.05)

Re = 20.75%.

And for preferred share,

10 = 1.5 x 1.05/(Rp - 0.05)

Rp = 20.75%.

The WACC is given as:

WACC = Rd x (1-T) x Debt percentage + Rp x Preferred share percentage + Re x Equity Percentage

WACC = 10 x 0.75 x 60/130 + 20.75 x 10/130 + 20.75 x 20/130 = 8.25%.

The low value of WACC is due to the high percentage of debt and reserves in the capital structure.