Question

Mackenzie Company’s current share price is $20 and it is expected to pay a $1 dividend per share next year. After that, the firm’s dividends are expected to grow at a rate of 4% per year. Mackenzie has some debt outstanding with a yield to maturity of 7%.

1. What is an estimate of Mackenzie’s cost of equity?

2. Mackenzie also has preferred stock outstanding that pays a $2 per share fixed dividend. If this stock is currently priced at $25, what is Mackenzie’s cost of preferred stock?

3. Mackenzie has 5 million common shares outstanding and 1 million preferred shares outstanding, and its equity has a total book value of $50 million. Its debts have a market value of $20 million. If Mackenzie’s common and preferred shares are priced as in parts (a) and (b), what is the market value of Mackenzie’s assets?

4. Mackenzie faces a 35% tax rate. Given the information in parts (a) to (d), and your answers to those problems, what is Mackenzie’s WACC?

Answer 1

a. Cost of equity=(Dividend1/Share price)+growth rate

=(1/20)+4%

=9%

b. Cost of preferred stock=Dividend/preferred share price=2/25=8%

After tax cost of debt=Before tax cost of debt*(1-tax rate)

before tax cost of debt=yield to maturity=7%

After tax cost of debt=Before tax cost of debt*(1-tax rate)=7%*(1-35%)=4.55%

c. Market value of equity=5 million shares*current share price=5*20=$100 million

Market value of preferred stock=1 million shares*preferred share=1*$25=$25 million

Market value of the debt=$20 million

Total market value=$100+$25+$20=$145 million

d. Weight of equity=Market value of the equity/Total market value=$100/$145=69.0%

Weight of preferred stock=$25/$145=17.2%

Weight of debt=$20/$145=13.8%

WACC=(weight of equity*cost of equity)+(weight of preferred stock*cost of preferred stock)+(weight of debt*after tax cost of debt)

=(69.0%*9%)+(17.2%*8%)+(13.8%*4.55%)

=8.21%