Question

A company has 3 million shares outstanding at a market price of $1.50 each. The company's bonds have a total market value of $2,700,000, have a coupon rate of 3% p.a. and currently yield 4% p.a. The current market value of preference shares is $500,000 and currently return 5% p.a. The company has a beta of 0.7, the market risk premium is 6% p.a., the risk-free return is 2% p.a., and the company tax rate is 30%,

What is the firm's weighted average cost of capital (WACC)?

[Be sure to show the calculation of each part of the WACC, and the final value for the WACC.]

Answer 1

Calculation of weights of the each component in WACC :-

Particulars	market value	weight ( market value of component / total value)
Debt	2,700,000	0.3507 ( 2,700,000/ 7,700,000)
Preferred stock	500,000	0.0649 (500,000/ 7,700,000)
Common stock	4,500,000	0.5844 ( 4,500,000 / 7,700,000)
Total value	7,700,000	1

Calculation of the cost of debt after tax :-

Cost of debt after tax = yield on bond * ( 1- tax rate)

= 4% * (1 - 0.30)

Cost of debt after tax = 2.8%

Cost of preferred stock = return on preferred stock = 5%

Calculation of the cost of equity :-

Cost of equity = Rf + Beta * market risk premium

= 2% + 0.7 * 6%

Cost of equity = 6.2%

Calculation of weighted average cost of capital (WACC) :-

Particulars	cost	weights	WACC
Debt	2.8%	0.3507	0.98196%
Preferred stock	5%	0.0649	0.3245%
Equity	6.2%	0.5844	3.62328%
WACC	4.92974%