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Homework answers / question archive / Your task is to find the cost of capital (WACC) for a company

Your task is to find the cost of capital (WACC) for a company

Finance

Your task is to find the cost of capital (WACC) for a company. The company has three sources of capital available. The marginal tax rate for the company is 20%.

Debt: 5000 discount bonds with $500 par value, with 6 year to maturity. Bonds currently offer 4% yield to bondholders.

Preferred stock: 24 000 shares outstanding with $110 market price and 5% yield.

Common stock: 200 000 shares outstanding with the book value of $20 but currently trading at P/B=2.0. One may apply CAPM to estimate the cost of equity. Inputs for estimations are: risk free rate 2.0%, expected market return (Rm) 10.0% and the stock beta is 1.5.

Find the cost of each financing source, capital structure weights for each source and finally WACC.

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Calculation of cost of financing of each source:

Cost of debt = Coupon rate * (1-tax rate) = 4% * (1-20%) = 4% * 80% = 3.2%

Cost of preference share = Yield rate = 5%

Cost of equity = Rf + [B * (Rm - Rf)] = 2% + [1.5 * (10% - 2%)] = 2% + [1.5 * 8%] = 2% + 12% = 14%

Calculation of capital structure weight of each source:

Exsiting structure:

Debt = 5000 bond * $500 = $2,500,000

Preference shares = 24,000 shares * $110 = $2,640,000

Equity shares = 200,000 shares * $20 * 2 = $8,000,000

Total Capital = $2,500,000 + $2,640,000 + $8,000,000 = $13,140,000

weight:

Debt = $2,500,000 / $13,140,000 = 19.03%

Preference shares = $2,640,000 / $13,140,000 = 20.09%

Equity shares = $8,000,000 / $13,140,000 = 60.88%

Calculation of WACC:

WACC = [(cost of debt * weight of debt) + (cost of preference share * weight of preference share) + (cost of equity share * weight of equity share)]

WACC = [(3.2% * 19.03%) + (5% * 20.09%) + (14% * 60.88%)]

WACC = [0.61% + 1% + 8.52%]

WACC = 10.13%

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