Question

METRA is considering building a new train line from Plainfield to Chicago. Use the following information to help Metra determine if they should pursue this project:

• Debt totals $150 million with a 5% coupon and has been outstanding for 2 years
• Common stock (8 million shares outstanding) now trade at $25 per share
• Bonds similar to METRA’s existing debt are currently priced at 102 (a premium)
• The common stock will pay an annual dividend of $1.20 this year, up from $0.80 nine years ago.
• METRA pays a corporate tax rate of 21%.
• The risk-free rate is 3%, the market return is 10%, and Metra’s common stock Beta is 1.2

1. What debt and equity weights will Metra use to calculate WACC?                         
2. What is METRA’s cost of debt?   
3. What is METRA’s cost of common equity?   
4. What is METRA’s WACC?       

Answer 1

Total equity value = No. of shares * share price = 8 million * $25 = $200 million

Total Debt value = Debt book value * market premium rate = $150 million * 102% = 153 million

(A) Weight of equity = Equity / total value of debt + equity = 200 / 353 = 56.66%

Weight of Debt = Debt / total value of debt + equity = 153 / 353 = 43.34%

(B) Cost of debt = Rate of interest * (1- tax rate ) = 5% * (1-21%) = 3.95%

(C) Cost of equity = CAPM = Rf + Beta*(Rm-Rf) = 3% + 1.2*(10% - 3%) = 11.4%

(D) WACC = (Weight of equity * cost of equity ) + (Weight of debt * cost of debt)

= (11.4% * 56.66%) + (3.95% * 43.34%) = 8.17%