honeycfa

A company has the following capital structure:

• Target weightings: 30% debt, 20% preferred stock, 50% common equity.
• Tax Rate: 35%.
• The firm can issue $1,000 face value, 7% semi-annual coupon debt with a 15-year maturity for a price of $1,047.46.
• An 8% dividend preferred stock issue has a value of $35 per share.
• The company’s growth rate is estimated at 6%.
• The company's common shares have a value of $40 and a dividend in year 0 of D₀ = $3.00.

The company's weighted average cost of capital is closest to:

A) 9.84%.

B) 9.28%.

C) 10.53%.

Step 1: Determine the after-tax cost of debt:

The after-tax cost of debt [k_d (1 – t)] is used to compute the weighted average cost of capital. It is the interest rate on new debt (k_d) less the tax savings due to the deductibility of interest (k_dt).

Here, we are given the inputs needed to calculate k_d: N = 15 × 2 = 30; PMT = (1,000 × 0.07) / 2 = 35; FV = 1,000; PV = -1,047.46; CPT → I = 3.25, multiply by 2 = 6.50%.

Thus, k_d (1 – t) = 6.50% × (1 – 0.35) = 4.22%

Step 2: Determine the cost of preferred stock:

Preferred stock is a perpetuity that pays a fixed dividend (D_ps) forever. The cost of preferred stock (k_ps) = D_ps / P

where:	Dps = preferred dividends.
	P = price

Here, D_ps = 0.08 × $35.00 = $2.80, so k_ps = D_ps / P = $2.80 / $35 = 0.08, or 8.0%.

Step 3: Determine the cost of common equity:

k_ce = (D₁ / P₀) + g

where:	D1 = Dividend in next year
	P0 = Current stock price
	g = Dividend growth rate

Here, D₁ = D₀ × (1 + g) = $3.00 × (1 + 0.06) = $3.18.

k_ce = (3.18 / 40) + 0.06 = 0.1395 or 13.95%.

Step 4: Calculate WACC:

WACC = (w_d)(k_d) + (w_ps)(k_ps) + (w_ce)(k_ce)

where w_d, w_ps, and w_ce are the weights used for debt, preferred stock, and common equity.

Here, WACC = (0.30 × 4.22%) + (0.20 × 8.0%) + (0.50 × 13.95%) = 9.84%.

Note: Your calculation may differ slightly, depending on whether you carry all calculations in your calculator, or round to two decimals and then calculate.

honeycfa

Helmut Humm, manager at a large U.S. firm, has just been assigned to the capital budgeting area to replace a person who left suddenly. One of Humm’s first tasks is to calculate the company’s weighted average cost of capital (WACC) – and fast! The CEO is scheduled to present to the board in half an hour and needs the WACC – now! Luckily, Humm finds clear notes on the target capital component weights. Unfortunately, all he can find for the cost of capital components is some handwritten notes. He can make out the numbers, but not the corresponding capital component.  As time runs out, he has to guess.

Here is what Humm deciphered:

• Target weights: w_d = 30%, w_ps = 20%, w_ce = 50%, where w_d, w_ps, and w_ce are the weights used for debt, preferred stock, and common equity.
• Cost of components (in no particular order): 6.0%, 15.0%, and 8.5%.
• The cost of debt is the after-tax cost.

If Humm guesses correctly, the WACC is:

A) 9.2%.

B) 9.0%.

C) 11.0%.

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If Humm remembers to order the capital components from cheapest to most expensive, he can calculate WACC. The order from cheapest to most expensive is: debt, preferred stock (which acts like a hybrid of debt and equity), and common equity.

Then, using the formula for WACC = (w_d)(k_d) + (w_ps)(k_ps) + (w_ce)(k_ce)

where w_d, w_ps, and w_e are the weights used for debt, preferred stock, and common equity.

WACC = (0.30 × 6.0%) + (0.20 × 8.5%) + (0.50 × 15.00%) = 11.0%.

honeycfa

The following data is regarding the Link Company:

• A target debt/equity ratio of 0.5
• Bonds are currently yielding 10%
• Link is a constant growth firm that just paid a dividend of $3.00
• Stock sells for $31.50 per share, and has a growth rate of 5%
• Marginal tax rate is 40%

What is Link's after-tax cost of capital?

A) 10.5%.

B) 12.0%.

C) 12.5%.

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Use the revised form of the constant growth model to determine the cost of equity. Use algebra to determine the weights for the target capital structure realizing that debt is 50% of equity. Substitute 0.5E for D in the formula below.

k_s = D₁ ÷ P₀ + growth = (3)(1.05) ÷ (31.50) + 0.05 = 0.15 or 15%

V = debt + equity = 0.5 + 1 = 1.5

WACC = (E ÷ V)(k_s) + (D ÷ V)(k_debt)(1 ? t)

WACC = (1 ÷ 1.5)(0.15) + (0.5 ÷ 1.5)(0.10)(1 ? 0.4) = 0.1 + 0.02 = 0.12 or 12%

honeycfa

In calculating the weighted average cost of capital (WACC), which of the following statements is least accurate?

A) Different methods for estimating the cost of common equity might produce different results.

B) The cost of preferred equity capital is the preferred dividend divided by the price of preferred shares.

C) The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding debt.

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After-tax cost of debt = bond yield ? tax savings = k_d ? k_dt = k_d(1 ? t)