Question

Consider the following capital structure for AAA Corporation. The company has one debt issue, preferred stock and common stock in its capital structure. The firm’s tax rate is 40%; the risk-free rate is 3%.

Details on the components of the capital structure are listed below.

Bond issue:

Preferred equity:

Common equity:

Coupon-paying issue
$100 million par
10% semiannual coupon
Remaining maturity of 15 years
Currently priced in market at 90% of par value

Coupon-paying issue
$50 million par
6% annual coupon
Currently priced to yield 12%

2 million shares outstanding Current share price: $50 Stock’s beta: 1.5
Market risk premium = 7.5%

8.) What is AAA’s cost of debt?

9.) What is the total market value of AAA’s preferred stock?

10.) What is AAA’s weighted average cost of capital?

Answer 1

	Value	Weight	Cost
Debt	90	41.9%	11.41%
Preferred	25	11.6%	12.00%
Equity	100	46.5%	14.25%
Total	215	WACC	10.89%

Cost of debt can be calculated using I/Y function on a calculator

N = 15 x 2 = 30, PMT = 10% x 1000 / 2 = 50, PV = -900, FV = 1000 => Compute I/Y = 5.70% (semi-annual)

Annual cost of debt = 5.70% x 2 = 11.41%

Market Value of preferred stock = 50 x 6% / 12% = 25 million

WACC = 41.9% x 11.41% x (1 - 40%) + 11.6% x 12% + 46.5% x 14.25% = 10.89%