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WACC
WACC. Look at the following book-value balance sheet for University Products Inc. The pre-ferred stock currently sells for $15 per share and pays a dividend of $2 a share. The common stock sells for $20 per share and has a beta of .8. There are 1 million common shares outstanding. The market risk premium is 10%, the risk-free rate is 6%, and the firm's tax rate is 40%. (L013-1)
BOOK-VALUE BALANCE SHEET (Figures in $ millions)
Assets Liabilities and Net Worth Cash and short-term securities $ 1 Bonds, coupon = 8%, paid annually (maturity = 10 years, current yield to maturity = 9%) $10 Accounts receivable 3 Preferred stock (par value $20 per share) 2 Inventories 7 Common stock (par value $.10) 0.1 Plant and equipment 21 Additional paid-in stockholders' equity 9.9 Retained earnings 10 Total $32 $32
a. What is the market debt-to-value ratio of the firm? b. What is University's WACC?
Expert Solution
Computation of Market Debt to Value Ratio:
Market Debt to Value Ratio = Market Value of Debt / Market Value of Firm
Here,
Computation of Market Value of Debt using PV Function in Excel:
=-pv(rate,nper,pmt,fv)
Here,
PV = Market Value of Debt = ?
Rate = 9%
Nper = 10 years
PMT = $10,000,000*8% = $800,000
FV = $10,000,000
Substituting the values in formula:
=-pv(9%,10,800000,10000000)
PV or Market Value of Debt = $9,358,234.23
Market Value of Firm = Market Value of Common Stock + Market Value of Preferred Stock + Market Value of Debt
= (1,000,000*$20) + (($2,000,000/$20)*$15) + $9,358,234.23
= $20,000,000 + $1,500,000 + $9,358,234.23
Market Value of Firm = $30,858,234.23
Market Debt to Value Ratio = $9,358,234.23/$30,858,234.23 = 30.33%
Computation of University's WACC:
WACC = Cost of Common Stock*Weight of Common Stock + Cost of Preferred Stock * Weight of Preferred Stock + Cost of Debt*(1-Tax Rate)*Weight of Debt
Here,
Cost of Common Stock = Risk-free Rate + Beta*Market Risk Premium
= 6% + 0.8*10%
= 6% + 0.08
Cost of Common Stock = 14%
Cost of Preferred Stock = Annual Dividend/Current Market Price
= $2/$15
Cost of Preferred Stock = 13.33%
Cost of Debt = Yield to Maturity = 9%
Weight of Common Stock = $20,000,000/$30,858,234.23 = 64.81%
Weight of Preferred Stock = $1,500,000/$30,858,234.23 = 4.86%
Weight of Debt = $9,358,234.23/$30,858,234.23 = 30.33%
WACC = 14%*64.81% + 13.33%*4.86% + 9%*(1-40%)*30.33% = 11.36%
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