Question

Peet's Coffee is considering a new project. It has a target capital structure of 50% debt, 45% equity and 5% preferred stock. Peet's has noncallable bonds outstanding, with a coupon rate of 8.5% (paid semiannually), that mature in 16 years with a face value of $1,000, and a market price of $985.45. The yield on the company's current bonds is a good approximation of the yield on any new bonds they issue. The company can sell shares of preferred stock that pay an annual dividend of $6 at a price of $35.45.

Peet's has retained earnings they will use to finance their project. They estimate their cost of equity using the CAPM approach. Their beta is 1.4, the risk-free rate is 2.2% and the expected market return is 7.8%. If they have a tax rate of 35.0%, what is the WACC for this project?

Answer #1

First of all lets find cost od debt ie YTM

YTM = Interest + ( Face value - current selling price)/n / ( Face value + current selling price)/2

Interest = 1000*8.5%/2 = 42.5$ , n = 16*2 = 32 , Face value = $1000 m Selling price = 985.45$

YTM = 42.5 + (1000-985.45)/32 / (1000+985.45)/2

=42.5 + 0.4547 / 992.725

=42.95469/992.725

=0.043269

Thus Annaulized YTM = 4.3269%*2 = 8.6539%

After tax cost of debt = 8.6539%(1-0.35)

=8.6539%(0.65)

=5.625%

Cost of preference = Dividend/Current stock price

=6/35.45

=16.93%

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

=2.2%+1.4(7.8%-2.2%)

=2.2%+1.4(5.6%)

=2.2%+7.84%

=10.04%

Statement showing WACC

Source of capital | Weight | K | WACC=W*K |

equity | 45% | 10.04% | 4.518% |

preference | 5% | 16.93% | 0.847% |

debt | 50% | 5.63% | 2.813% |

8.177% |

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