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 pts)

2. What is METRA’s cost of debt?     (3 pts)

3. What is METRA’s cost of common equity?     (3 pts)

4. What is METRA’s WACC?  

Answer 1

a)
Total value of firm = Maket value of debt + market value of equity
= $150 million + ($8 million * $25)
= $150 million + $200 million
= $350 million

Weight of debt = $150 m / $350 m = 0.4286 or 42.86%

Weight of equity = $200m / $350m = 0.5714 or 57.14%

b)
FV = 100
PV = 102
PMT = 100 * 5% = 5
Nper = 2

Cost of debt can be calculated by using the following excel formula:
=RATE(nper,pmt,pv,fv)
=RATE(2,5,-102,100)
= 3.94%

Before tax cost of debt = 3.94%

After tax cost of debt = 3.94% * (1 - 0.21) = 3.11%

c)
Cost of common equity = Rf + beta * (Rm - Rf)
= 3% + 1.2 * (10% - 3%)
= 3% + 1.2 * 7%
= 3% + 8.4%
= 11.4%

Cost of common equity = 11.4%

d)

WACC = (weight of debt * cost of debt) + (weight of equity * cost of equity)
= (42.86% * 3.11%) + (57.14% * 11.4%)
= 1.3341% + 6.5143%
= 7.85%

WACC = 7.85%