Question

Best Buy wants to determine an appropriate discount rate to apply to its investment in a new branch on the island of Grenada. The following information about the company’s capital structure is provided below. The company’s tax rate is 35 percent.
Debt 5,000 7 percent coupon bonds outstanding, $1,000 par value, 20 years to maturity, selling for 92 percent of par, the bonds make semiannual payments, YTM is 7.80%

Common stock 100,000 shares outstanding, selling for $57 per share; the beta is 1.15
Preferred stock 13,000 shares of 7 percent preferred stock outstanding, currently selling for $104 per share
Market 8 percent market risk premium and 6 percent risk-free rate

Required:
Find the company’s weighted average cost of capital (WACC).

Answer 1

Cost of debt = 7.80%

Cost of equity = Risk free rate + beta(market risk premium)

Cost of equity = 0.06 + 1.15 (0.08)

Cost of equity = 0.152 or 15.2%

Cost of preferred stock = (Annual dividend / price) * 100

Cost of preferred stock = (7 / 104) * 100

Cost of preferred stock = 6.7308%

Total market value of debt = 5,000 * 920 = 4,600,000

Total market value of common equity = 100,000 * 57 = 5,700,000

Total market value of preferred stock = 13,000 * 104 = 1,352,000

total market value = 4,600,000 + 5,700,000 + 1,352,000 = 11,652,000

WACC = (4,600,000 / 11,652,000)*0.078*(1 - 0.35) + (5,700,000 / 11,652,000)*0.152 + (1,352,000 / 11,652,000)*0.067308

WACC = 0.02002 + 0.07436 + 0.00781

WACC = 0.1023 or 10.23%

WACC = 0.0231 + 0.04306

WACC = 0.0662 or 6.62%