Question

Compute the weighted average cost of capital RIC Inc. using the following

information:

RIC Inc. has decided to finance this product line expansion by raising new capital. The company’s optimal capital structure calls for 35% debt, 40% equity, and 25% preferred stock. RIC Inc. can issue a series of 8% coupon bonds with a $ 1000 par value. The bonds will mature in 10 years and will sell for $ 946 minus an issuance cost of $ 5. RIC Inc.’s marginal tax rate is 35 %.

Answer: Cost of Debt is 5.80%

RIC Inc’s common stock is currently selling for $ 22 per share. Its present dividend is $ 1.96 a share and the expected long -term dividend growth rate is 8.5 %. What is the cost of external equity for RIC Inc. assuming an issuance cost of $ 2.00 per share?

Answer: Cost of External Equity is 19.13%

RIC Inc. has just issued shares of preferred stock that pay an annual dividend of $ 2.15. The preferred stock was sold to the public at a price of    $ 52.00 per share with an issuance cost of $ 2.00 per share. What is the marginal cost of preferred stock for RIC Inc.?

Answer: Cost of Preferred Stock is 4.30 %

Therefore WACC is 10.76%

(a)     Using the WACC, recalculate the NPV. Should RIC Inc. undertake the investment?

(b)     When should a company undertake an investment using the NPV?

(c)     Compare the IRR computed (2c) with the WACC. Should RIC Inc. go ahead with the project? ( A simple “Yes or No” will not do.)

(d)     When should a company undertake an investment using the IRR?

Answer 1

The WACC is :

Cost of debt will be :

FV = $1000

PMT = $80

N = 10 YEARS

PV = ($946 - $5 ) = ($941)

So, I/Y = 8.9159

So, the after tax cost of debt = 8.9159 * 0.65

=5.7853%

Cost of external equity is :

Re = D1/Po + g

= $2.1266/ $22- $2 + 0.085

=19.13%

Cost of preferred stock is :

= Dividend paid/ share price of preference share

=$2.15/$52- $2

= $2.15/$50

= 4.3%

So, the WACC is :

weight of debt*cost of debt + weight of equity*cost of equity + weight of preference share*cost of preference share

=0.35*5.7953% + 0.4*0.1913 + 0.25* 0.043

=0.0203 + 0.0765 + 0.0108

=10.755%

= 10.76% (rounded off to two decimal places)