Question

B currently has a $400 million market value of debt outstanding. This debt was contracted five years ago at the rate of 4%. B can refinance 60% of the debt at 5% with the remaining 40% refinanced at 6.5%. The company also has an issue of 2 million preference shares outstanding with a market price of $20 per share. The preference shares offer an annual dividend of $1.5 per share. B also has 14 million ordinary shares outstanding with a price of $30.00 per share. B just paid a $1.2 ordinary dividend, and that dividend is expected to increase by 5 per cent per year forever. If the corporate tax rate is 40 per cent, calculate B’s weighted average cost of capital (WACC).

Answer 1

WACC = weighted average of cost for various sources of capital where the weights are market values for the sources of capital

market value of equity = 10*30=300

market value of preference shares = 20*6 = 120

market value of 60% of debt =400*0.6 = 240

market value of 40% of debt = 400*0.4 = 160

cost of equity = dividend yield + growth = 1.2 * 1.06 / 30 + 0.06 = 10.24%

cost of preference share = dividend / price = 1.5 / 20 = 7.5%

total market value = 400+300+120 = 820 m

wacc = weight of equity * cost of equity + weight of debt * cost of debt *( 1 - tax rate ) + weight of preference share * cost of preference share

= 300/ 820 *10.24 + 240/820* 5 * 0.6 + 160/820*6.5*0.6 + 120/820*7.5

= 6.50%