Question

1. Show your work with the data below. (40 points) Calculate the WACC which represents the hurdle rate foratypical project with average risk using the average rate of the range of the marginal cost of common equity using retained earnings or new earnings. Data: A 15-year, 12% coupon, semiannual payment non-callable bonds sell for $1,153.72. New bonds will be privately placed with no flotation cost A 10%, $1,000 par value, annually dividend, perpetual preferred stock sells for $1,111. Both an existing common stock and a new common stock issue, which incurs a flotation cost of 10% of the proceeds, sells for $50. D = $4.3995 and g = 5%. B = 1.2; r = 7%; RP = 6%. Bond-Yield Risk Premium = 4%. Target capital structure: 20% debt, 20% preferred, 60% common equity. Tax rate is 40%. RF M

Answer 1

WACC = (weight of debt * cost of debt) + (weight of preferred stock * cost of preferred stock) + (weight of equity * cost of equity)

cost of debt = YTM of bond * (1 - tax rate)

YTM is calculated using RATE function in Excel with these inputs :

nper = 15*2 (15 years to maturity with 2 semiannual coupon payments each year)

pmt = 1000 * 12% / 2 (semiannual coupon payment = face value * annual coupon rate / 2. This is a positive figure as it is an inflow to the bondholder)

pv = -1153.72 (current bond price . This is a negative figure as it is an outflow to the buyer of the bond)

fv = 1000 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)

the RATE is calculated to be 5.00%. This is the semiannual YTM. To calculate the annual YTM, we multiply by 2. Annual YTM is 10.00%

A10 fo C =RATE(15*2,1000*12%/2,-1153.72,1000) D G B 10 10 -4.00 5.00%!

cost of debt = YTM * (1 - tax rate)

cost of debt = 10.00% * (1 - 40%) ==> 6%

cost of preferred stock = dividend / current price

dividend = face value * dividend rate = $1000 * 10% = $100.

cost of preferred stock = $100 / $1,111 = 9%

cost of equity (CAPM) = risk free rate + (beta * market risk premium)

cost of equity (CAPM) = 7% + (1.2 * 6%) ==> 14.20%

cost of equity (Gordon model) = (next year dividend / net proceeds per share) + constant growth rate

net proceeds per share = current share price - flotation cost

net proceeds per share = $50 - ($50 * 10%) = $45.

cost of equity (Gordon model) = ($4.3995 / $45) + 5% = 14.78%

cost of equity (bond yield plus risk premium approach) = risk free rate + risk premium

cost of equity (bond yield plus risk premium approach) = 7% + 4% = 11%

cost of equity = average of three methods = (14.20% + 14.78% + 11%) / 3 = 13.33%

WACC = (weight of debt * cost of debt) + (weight of preferred stock * cost of preferred stock) + (weight of equity * cost of equity)

The weights to use are the target weights.

WACC = (20% * 6%) + (20% * 9%) + (60% * 13.33%%) ==> 11.00%