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Homework answers / question archive / Jupiter Ltd wants to calculate its weighted average cost of capital (WACC)
Jupiter Ltd wants to calculate its weighted average cost of capital (WACC). The company’s financial manager has collected the following information:
• The company recently issued a long-term bond at $1,000 of par. It pays $40 coupon interest every six months. The bond is still traded at par value in the market.
• Long-term Treasury bond yield is 6% and short-term Treasury bill yield is 4%.
• S&P 500 index’s expected return is 10%.
• The estimate of beta for the company is 1.3. This estimate is expected to remain stable in the future as well.
• The company’s stock price is $32 per share and $30 per share for the common stock and preferred stock, respectively.
• The company recently paid a common stock dividend of $2 per share and a preferred stock dividend of $2.5 per share.
• The company pays a 10% and 7% flotation costs whenever it issues new common stock and preferred stock, respectively.
• The company’s common stock dividend is expected to grow at a constant rate of 6% while the preferred stock dividend is fixed.
• The company’s optimal capital structure is 70% common equity, 5% preferred stock and 25% debt.
• The company’s tax rate is 40%.
• The company anticipates issuing new common stocks during the upcoming year. Required:
a. What is the best estimate of Jupiter’s after-tax cost of debt to be used for calculating WACC? (2 marks)
b. What is Jupiter’s cost of retained earnings generated internally (rs), and cost of new common stock from new issuance (re)?
rs using CAPM
rs using DCF
re using DCF (6 marks)
c. Why re > rs in general?
Best Estimate of After Tax Cost of Debt :
Given that the Bond is traded at Par therefore Coupon Rate is equal (40 / 1000) i.e 4% semiannual or 8% Annual is to be taken as pre tax cost of debt.
After Tax Cost of Debt = Pre tax cost of debt * (1 - Tax rate)
= 8% * (1 - 0.40)
= 4.8%
(b.) Calculation of Cost of Equity using CAPM :
As per CAPM (rs using CAPM)
Cost of Equity = Risk free Rate + Beta * (Return from Market - Risk Free Rate)
Long term treasury Bond Yield is risk Free rate i.e 6%
Cost of Equity = 6% + 1.3 * (10% - 6%)
= 11.2%
Cost of Equity (rs using DCF )
Cost of Equity = [Expected Dividend / Current Price] + Growth rate
= [(2 * 1.06) / 32] + 0.06
= 12.625%
Cost of Equity (re using DCF )
Cost of Equity = [Expected Dividend / Current Price] + Growth rate
= [(2 * 1.06) / (32 - 3.2)] + 0.06
= 13.36%
(c.) Why re > rs in general because of the floatation cost because flotation cost is not involved in retained earnings.
