Question

Given the following information for Watson Power Co., find the WACC. Assume the companyâs tax rate is 21 percent.
Debt: 15,000 bonds with a 5.8 percent coupon outstanding, $1,000 par value, 25 years to maturity, selling for 108 percent of par; the bonds make semiannual payments.
Common stock: 575,000 shares outstanding, selling for $64 per share; the beta is 1.09.
Preferred stock: 35,000 shares of 2.8 percent preferred stock outstanding, currently selling for $65 per share.
Market: 7 percent market risk premium and 3.2 percent risk-free rate.
Required:
What is the company's WACC? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16)

Answer 1

Answer:

8.60%        

Explanation:

For computing the WACC first we need to find the following items

Debt:

Value of Debt  is

= Number of bonds × Par value  × Given percentage

= 15,000 × $1,000 × 108%

=  $16,200,000

Now

Par Value = $1,000

So,

Current Price is

= 108% × $1,000

= $1,080

Given that

Annual Coupon Rate = 5.8%

So, Semiannual Coupon Rate = 2.90%

Now its Semiannual Coupon amount is  = 2.90% × $1,000 = $29

Time period = 25 years

Semiannual time period = 50  years

Let  we assume the semiannual yield to maturity be x%

Current Price = Coupon amount × PVIFA (x%, time period) + Par value × PVIF(x%, time period)

$1,080 = $29 * PVIFA(x%, 50) + $1,000 × PVIF(x%, 50)

Using financial calculator:

N = 50

PV = -$1,080

PMT = 29

FV = $1,000

We got the X i.e interest rate is 2.612%

Semiannual YTM = 2.612%

Annual YTM = 2 × 2.612%   = 5.224%

Now this is a before tax cost of debt

So, after cost of debts is

= Before tax cost of debt × (1 - tax rate)

= 5.224% × (1 - 0.21)

= 4.127%

For  Common Stock:

As we know that

Expected Rate of Return = Risk Free Rate + Beta × Market Risk Premium

= 0.032 + 1.09 × 0.07

= 0.032 + 0.0763

= 0.1083 or 10.83%

Now

Value of Equity is

= Number of outstanding shares × selling price per share

= 575,000  × $64

= $36,800,000

For Preferred Stock:

Cost of Preferred Stock = Expected Dividend ÷ Current Price

where,

Expected Dividend = $100 × 2.8% = $2.80

So,

Cost of Preferred Stock = 2.80 ÷ $65

= 4.308%

Now

Value of Preferred Stock = 35,000 × $65

= $2,275,000

So,  

Value of Firm = Debt value + Common Stock value + Preferred Stock  value

= $16,200,000 + $36,800,000 + $2,275,000

= $55,275,000

Weight of Debt  is

= Debt value ÷ Total value of firm

= $16,200,000 ÷ $55,275,000

= 0.2930  

Weight of Common Stock

= Common stock value ÷ Total firms value

= $36,800,000 ÷ $55,275,000

= 0.6658

Weight of Preferred Stock

= Preferred stock value ÷ Total firms value

= $2,275,000 ÷ $55,275,000

= 0.0412

Now

WACC = (Weight of Debt × After-tax Cost of Debt) + (Weight of Common Stock × Cost of Common Stock)+ (Weight of Preferred Stock × Cost of Preferred Stock )

= (0.2930  × 0.04127) + (0.6658 ×  0.1083) + (0.0412 × 0.04308)

= 1.209211 + 7.210614 + 0.17749

= 8.60%