Question

Growth​ Company's current share price is $ 20.15 and it is expected to pay a $ 1.30 dividend per share next year. After​ that, the​ firm's dividends are expected to grow at a rate of 4.5 % per year.

a. What is an estimate of Growth​ Company's cost of​ equity?

b. Growth Company also has preferred stock outstanding that pays a $ 2.00 per share fixed dividend. If this stock is currently priced at $ 27.85​, what is Growth​ Company's cost of preferred​ stock?

c. Growth Company has existing debt issued three years ago with a coupon rate of 6.4 %. The firm just issued new debt at par with a coupon rate of 6.2 %. What is Growth​ Company's cost of​ debt?

d. Growth Company has 5.1 million common shares outstanding and 1.3 million preferred shares​ outstanding, and its equity has a total book value of $ 50.0 million. Its liabilities have a market value of $ 19.8 million. If Growth​ Company's common and preferred shares are priced as in parts ​(a​) and ​(b​), what is the market value of Growth​ Company's assets?

e. Growth Company faces a 40 % tax rate. Given the information in parts ​(a​) through ​(d​), and your answers to those​ problems, what is Growth​ Company's WACC? ​Note: Assume that the firm will always be able to utilize its full interest tax shield.

Answer 1

a). kE = [D1 / P0] + g

= [$1.30/$20.15] + 0.045 = 0.0645 + 0.045 = 0.1095, or 10.95%

b). kP = Annual Dividends / Current Share Price = $2 / $27.85 = 0.0718, or 7.18%

c). The pre-tax cost of debt is the firm’s YTM on current debt. Since the firm recently issued debt at par, then the coupon rate of that debt must be equal to the YTM of the debt. Thus, the pre-tax cost of debt is 6.2%.

d). Market value of debt = $19.8 million

Market value of preferred stock = $27.85 per share x 1.3 million preferred shares = $36.205 million

Market value of equity = $20.15 per share × 5.1 million shares outstanding = $102.765 million

Market value of assets = $19.8 + $36.205 + $102.765 = $158.77 million

e). WACC = [wD x kD x (1 - t)] + [wP x kP] + [wE x kE]

= [(19.8/158.77) x 6.2% x (1 - 0.40)] + (36.205/158.77) x 7.18%] + [(102.765/158.77) x 10.95%]

= 0.46% + 1.64% + 7.09% = 9.19%