Question

Consider the case of Purple Panda Products 9.5452 Purple Panda Products is considering a new project that will require an initial investment of $45 million. It has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. Purple Panda has noncallable bonds outstanding that mature in five years with a face value of $1,000, an annual coupon rate of 10%, and a market price of $1,050.76. The yield on the company's current bonds is a good approximation of the yield on any new bonds that it issues. The company can sell new shares of preferred stock that pay an annual dividend of $9 at a price of $95.70 per share. Assume that Purple Panda new preferred shares can be sold without incurring flotation costs. Purple Panda does not have any retained earnings available to finance this project, so the firm will have to issue new common stock to help fund it. Its common stock is currently selling for $33.35 per share, and it is expected to pay a dividend of $2.78 at the end of next year. Flotation costs will represent 3% of the funds raised by issuing new common stock. The company is projected to grow at a constant rate of 9.2%, and they face a tax rate of 40%. Purple Panda's WACC for this project will be: O 0 10.00% 10.50% 9.00% 8.50% 0

Answer 1

The After-tax Cost of Debt

Reasonable estimate for the After-tax cost of Debt is the after-tax Yield to maturity of (YTM) of the Bond and is calculated using financial calculator as follows (Normally, the YTM is calculated either using EXCEL Functions or by using Financial Calculator)

· The Yield to maturity of (YTM) of the Bond is the discount rate at which the Bond’s price equals to the present value of the coupon payments plus the present value of the Face Value/Par Value

· The Yield to maturity of (YTM) of the Bond is the estimated annual rate of return expected by the bondholders for the bond assuming that the they hold the Bonds until it’s maturity period/date.

· The Yield to maturity of (YTM) of the Bond is calculated using financial calculator as follows (Normally, the YTM is calculated either using EXCEL Functions or by using Financial Calculator)

Variables	Financial Calculator Keys	Figure
Face Value [$1,000]	FV	1,000
Coupon Amount [$1,000 x 10%]	PMT	100
Yield to Maturity (YTM)	1/Y	?
Time to Maturity [5 Years]	N	5
Bond Price [-$1,050.76]	PV	-1,050.76

We need to set the above figures into the financial calculator to find out the Yield to Maturity of the Bond. After entering the above keys in the financial calculator, we get the yield to maturity (YTM) on the bond = 8.70%

After Tax Cost of Debt = Yield to maturity x (1 – Tax Rate)

= 8.70% x (1 – 0.40)

= 8.70% x 0.60

= 5.22%

Cost of Preferred Stock

Cost of Preferred Stock = Preferred Dividend / Selling Price of the Share

= [$9.00 / $95.70] x 100

= 9.40%

Cost of Common Stock

Dividend in year 1 (D1) = $2.78 per share

Current selling price per share (P0) = $33.35 per share

Dividend growth Rate (g) = 9.20% per year

Flotation Cost (FC) = 3.00%

Therefore, the Cost of Common Stock = [D1 / {P0(1 – FC)] + g

= [$2.78 / {$33.35 x (1 – 0.03)}] + 0.0920

= [$2.78 / $32.35] + 0.0920

= 0.0859 + 0.0920

= 0.1779 or

= 17.79%

Weighted Average Cost of Capital (WACC)

Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of Preferred stock x Weight of preferred stock] + [Cost of equity x Weight of Equity]

= [5.22% x 0.58] + [9.40% x 0.06] + [17.79% x 0.36]

= 3.03% + 0.56% + 6.41%

= 10.00%

“Hence, Purple Panda’s WACC will be 10.00%”