Question

Julie Gates, a recent Finance graduate, has been hired as a financial analyst in Macroworld’s corporate finance department. Macroworld is a large computer software and sometimes hardware & electronic gadget company. Julie’s first major assignment has her involved with the analysis of three different capital budgeting projects. The first involves opening for the first time a chain of boutique Macroworld Shoppe retail stores where customers could buy Macroworld products & third-party accessories and bring in their Macroworld software equipped computers and other Macroworld devices for training and technical support at the in-store Brilliant Lounge. The second project involves the development and sale of a new productivity software suite. This new software suite would be called MacroOffice. The third project involves the potential development and sale of smartphones, phablet phones, and slim 7- and 10-inch slate tablet devices called the M-Mobile.

Before analyzing these potential projects, Julie must estimate Macroworld’s weighted average cost of capital. This process involves finding the market value proportions of the company’s outstanding long-term financial securities as an estimate of the company’s capital structure and then estimating investors’ required returns on each type of the company’s securities which will be

Macroworld’s component capital cost estimates. In the following three exhibits Julie has been given balance sheet data and market data to help her with her task.

Exhibit 1: Macroworld Balance Sheet Data (in billions of dollars)
Long-term bonds	30.0
Preferred Stock	10.0*
Common Equity	80.0*
Total Long-term Financing	120.0
*Macroworld has 0.2 billion shares of preferred stock and 4 billion shares of common stock outstanding.

Exhibit 2: Market Price Data

Long-term semi-annual coupon bonds have a total par value of $30 billion, an annual coupon rate of 5.2 percent, 25 years to maturity, and currently have a price equal to 110% of their par value.

Preferred stock has a dividend yield of 7.5% of the stock’s $50 par value. This preferred stock currently sells for $53 per share.

Exhibit 3: Market and Company Forecasts and Other Information

The 10-year Treasury bond rate is 2.7%. The company expects/requires an overall stock market return of 11.5%.

Macroworld’s beta is 0.90. The company’s marginal tax rate is 40%.

Stock market analysts (and Macroworld) expect the company’s dividends and earnings to grow at a constant 8 percent annual rate for the foreseeable future.

Julie has been asked to answer the following questions. Julie has asked you for your help in answering these questions.

1. What financing proportions of debt (long-term bonds), preferred stock, and common equity should Julie use in her weighted average cost of capital calculation (WACC)?

Answer 1

WACC (Weighted average cost of capital):

Weighted Average of common equity is the percentage of equity component in the total long term financing obligation, i.e.,

= 80/120 = 66.67%

Weighted Average of Preferred equity is the percentage of preferred equity component in the total financial obligation., i.e.,

8.33%

Weighted Average of long-term debt = 30/120 = 25%

Beta = 0.9

Tax rate = 40%

Equity rate of return =

8+ 0.9( 11.5-8)

11.15%

preferred share holder return = 7.5%

WACC= W_e r_e + W_p r_p +W_d r_d(1-t)

= 66.67*11.5 + 8.33*7.5 + 25*5.2(1-0.40)

= 9.07%