Question

Meacham Corp. wants to raise financing to purchase a competitor. It can issue 12 year bonds with a 9% annual coupon for $1090 and will incur debt flotation costs of $15 per bond.The company can sell additional equity shares to the public for $30 per share and estimates its equity flotation costs will be $3 per share. Meacham paid a $4 per share dividend yesterday and expects is dividends to grow 7% annually. The company is targeting a capital structure of 40% debt and 60% common equity and has a 35% marginal tax rate.Calculate the company's WACC.

Answer 1

Answer:

           COST OF BOND

Year   Cashflow    DF@10%      PV           DF@5%     PV

               $                                 $                                  $

  0        (1,075)           1           (1,075)           1          (1,075)

1-12     58.50         6.8137      399          8.8633       519

12       1,000          0.3186      319            0.5568       557

                                  NPV      (357)              NPV         1                    

Kd = LR     + NPV1/NPV1+NPV2    x (HR – LR)

Kd = 5       + 1/1 + 357   x (10 – 5)

Kd = 5       + 1/358 x 5

Kd = 5.01%    

Ke = Do(1 +g)/Po-Fc + g

Ke = $4(1 + 0.07)/$30-$3 + 0.07

Ke = $4(1.07)/$27  + 0.07

Ke = 0.1585 + 0.07

Ke  = 0.2285 = 22.85%

WACC = Ke(E/V) + Kd(D/V)

WACC = 22.85(60/100) + 5.01(40/100)

WACC = 13.71 + 2.004

WACC = 15.71%

Explanation:

In this question, we need to calculate cost of debt using IRR formula. The cashflow for year 0 is the current market price less floatation cost. The cashflow for year 1 to 12 is the after-tax coupon, which is calculated as R(1 -T). R = 9% x $1,000 = $90 and R(1 -T) = $90(1-0.35) = $58.50. The cashflow for year 12 is the par value. we will discount the cashflows so as to obtain the net present value.

We will also calculate cost of equity. which is a function of dividend paid, current market price and growth rate.

Finally, we will calculate the weighted average cost of capital by considering the cost of each stock and the proportion of each stock in the capital structure.