Question

Nature Valley has 400,000 shares of common stock outstanding at a market price of $28 a share. Last month, Nature Valley paid an annual dividend in the amount of $1.00 per share. The dividend growth rate is 6%. Nature Valley also has 20,000 bonds outstanding with a face value of $1,000 per bond. The bonds carry a 6% coupon, pay interest annually, and mature in 10 years. The bonds are sold at par. The company's tax rate is 25%. What is Nature Valley's weighted average cost of capital? (Hint: Use the DDM to determine the cost of equity)

7.19%

6.40%

7.42%

6.75%

6.12%

Answer 1

Since bond is sold at par, coupon rate will be equal to yield to maturity

Before tax cost of debt = 6%

After tax cost of debt = 0.06 (1 - 0.25)

After tax cost of debt = 0.045 or 4.5%

Cost of equity = (D1 / share price) + growth rate

Cost of equity = [(1 * 1.06) / 28] + 0.06

Cost of equity = 0.03786 + 0.06

Cost of equity = 0.09786 or 9.786%

Market value of bond = 20,000 * 1000 = 20,000,000

Market value pf equity = 400,000 * 28 = 11,200,000

Total market value = 20,000,000 + 11,200,000 = 31,200,000

Weighted average cost of capital = Weight of equity*cost of equity + weight of debt*after tax cost of debt

Weighted average cost of capital = (11,200,000 / 31,200,000)*0.09786 + (20,000,000 / 31,200,000)*0.045

Weighted average cost of capital = 0.03513 + 0.02885

Weighted average cost of capital = 0.064 or 6.40%