Question

The CFO of Floki's Shipbuilding has hired you to work in their finance department. Your first project is to calculate the company's weighted average cost of capital (WACC). You have Floki's financial statements as well as the information below for your calculations.

Short-term debt consists of bank loans at 4% and is used for seasonal working capital needs. In the off-season short term, debt is zero.

Long-term debt consists of bonds with a 7% coupon, paid semi-annually and mature in 10 years. They are priced at 108 of par. New bonds would be issued at par and underwriting and other issuance costs would be 2% of their face value.

Floki's common shares have a market value of $6.40 per share. Their most recent dividend was $0.15. Long run growth estimate for the company is 7% . The firm has a beta of 0.9 and the yield on government bonds is 4%. The yield on the market portfolio is expected to be 12%. Determine the cost of common equity using the simple average of the dividend valuation and capital asset pricing model approaches. Assume that Floki’s common equity is from internal sources. The company's tax rate is 31%.

Compute Floki Shipbuilding's weighted average cost of capital.

Floki's Shipbuilding Company Income Statement
For the Period (Millions USD)	2020
Revenue	270
Cost Of Goods Sold	154
Gross Profit	116
Selling General & Admin Exp.	74
Depreciation & Amort.	11
Operating Income	32
Interest Expense	6
Earnings Before Tax	26
Income Tax Expense	8
Net Income	18
Per Share Items
EPS	0.40
Common Shares Outstanding	44.1
Dividends per Share	$0.15
Payout Ratio %	36.9%
Floki's Shipbuilding Company
Balance Sheet (Millions USD)	2020
ASSETS
Cash And Equivalents	-
Accounts Receivable	21
Inventory	120
Prepaid Exp.	4
Total Current Assets	145
Gross Property, Plant & Equipment	244
Accumulated Depreciation	(86)
Net Property, Plant & Equipment	158
Other long term operating assets	52
Total Assets	355
LIABILITIES
Accounts Payable	26
Accrued Exp.	-
Short-Term Debt	37
Other Current Liabilities	14
Total Current Liabilities	76
Long-Term Debt (Par value)	70
Other Non-Current Liabilities	29
Total Liabilities	176
Total Equity	179
Total Liabilities And Equity	355

Answer 1

	Calculation of WACC
1	Cost of Long Term debt
	YTM or Yield to Maturity is the applicable cost for LT debt here.
	YTM = [ Annual Interest +(Face Value-Market Price)/Years to maturity]/(Face value+2.Maketvalue)/3
	interest payment/year @7%			7
	Face value			100
	Market price =			108
	Years to maturity =			10
	For New Bonds issue cost will be @2%=			2
	Net Price receievable =108-2			106
	YTM =[7+(100-106)/10]/(100+2*106)/3
	YTM =6.15%
	Corporate Tax arte =31%
	Post Tax cost of LT debt=6.15%*(1-31%)=4.25%

2	Cost Of Equity
	Cost of Equity as per CAPM
	Stock beta =		0.9
	Risk free rate=Rf		4.00%
	Market return Rate =Rm=		12%
	Risk Premium Rp=Rm-Rf=		8%
	Required return on stock = Rf +Rp*beta
	Cost of Equity=4%+0.9*8%
	=11.2%

	Cost of Equity by Div Growth model
	Ke=d0(1+g)/P0   +g
	Where Ke=cost of equity
	d0=Current dividend=	$                           0.15
	g= dividend growth rate=	7%
	P0=current share price ex dividend=	$                             6.4
	So , Ke=0.15*(1+0.07)/6.4 +0.07
	Ke=9.51%

	Now Equity cost
	As per CAPM=	11.20%
	As per Div growth model =	9.51%
	Average of two=	10.36%

3	Calculation of WACC
	Ignoring short term debt as it is only for working capital needs
	Using Book Value of Capitals for weightage in the absence of details required for Market Balue consideration
	Type of Capital	Book Value $M	Weight	Post Tax cost	WACC
	LT Debt	70	28%	4.25%	1.19%
	Equity	179	72%	10.36%	7.45%
	Total	249			8.64%
	So WACC of Floki Shipbuilding is 8.64%