You are given the following information for Watson Power Co. Assume the company’s tax rate is 30 percent.

You are given the following information for Watson Power Co. Assume the company’s tax rate is 30 percent.

Debt:	9,000 6.4 percent coupon bonds outstanding, $1,000 par value, 20 years to maturity, selling for 107 percent of par; the bonds make semiannual payments.
Common stock:	360,000 shares outstanding, selling for $54 per share; the beta is 1.10.
Preferred stock:	14,000 shares of 4 percent preferred stock outstanding, currently selling for $74 per share.
Market:	11 percent market risk premium and 4.4 percent risk-free rate.

What is the company's WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

WACC

%

 

Explanation:

We will begin by finding the market value of each type of financing. We find:

MVD = 9,000($1,000)(1.07) = $9,630,000

MVE = 360,000($54) = $19,440,000

MVP = 14,000($74) = $1,036,000

And the total market value of the firm is:

V = $9,630,000 + 19,440,000 + 1,036,000

V = $30,106,000

Now, we can find the cost of equity using the CAPM. The cost of equity is:

RE = .044 + 1.10(.11)

RE = .1650, or 16.50%

The cost of debt is the YTM of the bonds, so:

P0 = $1,070 = $32.00(PVIFAR%,40) + $1,000(PVIFR%,40)

R = 2.902%

YTM = 2.902% × 2 = 5.80%

And the aftertax cost of debt is:

RD = (1 – .30)(.0580)

RD = .0406, or 4.06%

The cost of preferred stock is:

RP = $4 / $74

RP = .0541, or 5.41%

Now we have all of the components to calculate the WACC. The WACC is:

WACC = .0406(9.630 / 30.106) + .1650(19.440 / 30.106) + .0541(1.036 / 30.106)

WACC = .1214, or 12.14%

Notice that we didn’t include the (1 – TC) term in the WACC equation. We used the aftertax cost of debt in the equation, so the term is not needed here.

Dinklage Corp. has 6 million shares of common stock outstanding. The current share price is $85, and the book value per share is $8. The company also has two bond issues outstanding. The first bond issue has a face value of $65 million, a coupon rate of 8 percent, and sells for 95 percent of par. The second issue has a face value of $40 million, a coupon rate of 9 percent, and sells for 108 percent of par. The first issue matures in 23 years, the second in 5 years.

Dinklage Corp. has 6 million shares of common stock outstanding. The current share price is $85, and the book value per share is $8. The company also has two bond issues outstanding. The first bond issue has a face value of $65 million, a coupon rate of 8 percent, and sells for 95 percent of par. The second issue has a face value of $40 million, a coupon rate of 9 percent, and sells for 108 percent of par. The first issue matures in 23 years, the second in 5 years.

Suppose the most recent dividend was $5.70 and the dividend growth rate is 4 percent. Assume that the overall cost of debt is the weighted average of that implied by the two outstanding debt issues. Both bonds make semiannual payments. The tax rate is 38 percent. What is the company’s WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

  

WACC

%

 

Explanation:

The market value of equity is the share price times the number of shares, so:

MVE = 6,000,000($85)

MVE = $510,000,000

Using the relationship that the total market value of debt is the price quote times the par value of the bond, we find the market value of debt is:

MVD = .95($65,000,000) + 1.08($40,000,000)

MVD = $104,950,000

This makes the total market value of the company:

V = $510,000,000 + 104,950,000

V = $614,950,000

And the market value weights of equity and debt are:

E/V = $510,000,000 / $614,950,000

E/V = .8293

D/V = 1 – E/V = .1707

Next, we will find the cost of equity for the company. The information provided allows us to solve for the cost of equity using the dividend growth model, so:

RE = [$5.70(1.04) / $85] + .04

RE = .1097, or 10.97%

Next, we need to find the YTM on both bond issues. Doing so, we find:

P1 = $950 = $40(PVIFAR%,46) + $1,000(PVIFR%,46)

R = 4.249%

YTM = 4.249% × 2 = 8.50%

P2 = $1,080 = $45(PVIFAR%,10) + $1,000(PVIFR%,10)

R = 3.536%

YTM = 3.536% × 2 = 7.07%

To find the weighted average aftertax cost of debt, we need the weight of each bond as a percentage of the total debt. We find:

xD1 = .95($65,000,000) / $104,950,000

xD1 = .5884

xD2 = 1.08($40,000,000) / $104,950,000

xD2 = .4116

Now we can multiply the weighted average cost of debt times one minus the tax rate to find the weighted average aftertax cost of debt. This gives us:

RD = (1 – .38)[(.5884)(.0850) + (.4116)(.0707)]

RD = .0491, or 4.91%

Using these costs and the weight of debt we calculated earlier, the WACC is:

WACC = .8293(.1097) + .1707(.0491)

WACC = .0994, or 9.94%