Question

The Imaginary Products Co. currently has debt with a market value of $275 million outstanding. The debt consists of 9 percent coupon bonds (semiannual coupon payments) which have a maturity of 15 years and are currently priced at $1,392.42 per bond. The firm also has an issue of 2 million preferred shares outstanding with a market price of $11. The preferred shares pay an annual dividend of $1.20. Imaginary also has 14 million shares of common stock outstanding with a price of $20.00 per share. The firm is expected to pay a $2.20 common dividend one year from today, and that dividend is expected to increase by 6 percent per year forever. If Imaginary is subject to a 40 percent marginal tax rate, then what is the firm’s weighted average cost of capital?

Calculate the cost of debt.?

What is the firm’s weighted average cost of capital?

Answer 1

	Market values (in Millions)	Formula	Notes
Debt	275
Preferred shares	22	2M*11 per share
Equity shares	280	14M*20 per share
Total capital	577
Cost of debt	5.40%	0.09*(1-0.4)	Debt interest is tax deductable
Cost of preference shares	10.91%	1.2 Dividend/11 market price	Dividend is not tax deductable. To find the % cost, divide Dividend by market price
Cost of equity shares	17%	2.2 Dividend/20 market price +0.06 growth	Dividend/Market price + Growth
WACC calculation	Market values (in Millions)	Cost of capital	WACC	Formula
Debt	275	5.40%	2.57%	5.4%*275/577
Preferred shares	22	10.91%	0.42%	10.91%*22/577
Equity shares	280	17.00%	8.25%	17*280/577
Total	577		11.24%

1. Cost of debt = 5.4%

2. WACC = 11.24%