Assume You Are The Assistant To The CFO Of Xyz Company

Assume That You Are The Assistant To The Cfo Of Xyz Company Your Tas

Assume that you are the assistant to the CFO of XYZ Company. Your task is to estimate XYZ's WACC using the following data: The firm's tax rate is 40%. The current price of the 12% coupon, semiannual payment, non-callable bonds with 15 years to maturity is $1,153.72. New bonds could be issued with no flotation costs. The current price of the firm's 10% $100 par value, quarterly dividend, perpetual preferred stock is $116.95. The flotation costs on a new issue would be 5% of the proceeds. The current price of the common stock is $50 per share. The last dividend was $4.19, and dividends are expected to grow at a constant rate of 5%. The firm's beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is 6%. The target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.

Paper For Above instruction

Calculating the Weighted Average Cost of Capital (WACC) is a fundamental financial task that combines the costs of various sources of capital, considering their proportions in a company's capital structure. In the context of XYZ Company, the main sources of capital include long-term debt, preferred stock, and common equity. Accurate estimation of WACC is essential for investment appraisal, valuation, and financial decision-making.

Sources of Capital and Their Relevance in WACC Estimation

The primary sources of capital to be included in XYZ’s WACC calculation are debt, preferred stock, and common equity. These sources reflect the firm's overall cost of financing its operations and investments. When estimating WACC, it is crucial to incorporate all contractual and intended capital sources to provide a realistic measure of the company's overall cost of capital. Equity can be in the form of retained earnings or new equity, and debt includes bonds and loans.

Component Costs: Pre-tax or After-tax?

The component costs should be estimated on an after-tax basis for debt because interest expense is tax-deductible, reducing the effective cost of debt to the firm. Consequently, the use of after-tax cost of debt aligns with the firm's after-tax cash flows. For equity and preferred stock, taxes do not directly affect the component cost; hence, their costs are estimated on a pre-tax basis and incorporated into WACC accordingly. This ensures consistency with the tax shield benefit derived from debt financing.

Historical or Marginal Costs?

The component costs used in WACC should be marginal costs—costs of raising the next dollar of capital—rather than historical costs. This is because WACC aims to reflect the current costs of financing new investments, which are relevant for strategic decision-making. Marginal costs take into account prevailing market conditions, current risk premiums, and the firm's specific circumstances, providing a more accurate measure for evaluating upcoming projects.

Market Interest Rate on XYZ's Debt and Cost of Debt

The market interest rate on XYZ's debt can be derived from the yield to maturity (YTM) on existing bonds. Using the bond price of $1,153.72, a coupon rate of 12% paid semiannually, and 15 years to maturity, the YTM approximates the market cost of debt. Calculations indicate that the YTM is close to 10%, which reflects the current effective cost to XYZ for its debt financing. Adjusting for taxes, the after-tax cost of debt becomes 10% × (1 − 0.40) = 6%.

Cost of Preferred Stock

The cost of preferred stock is calculated as the dividend divided by the net issue price, after considering flotation costs. The annual dividend is 10% of $100 par value, equaling $10. The net proceeds from issuing the preferred stock are $116.95 minus 5% flotation costs, which equals approximately $111.10. Therefore, the cost of preferred stock is $10 / $111.10 ≈ 9%. This rate is lower than the yield to maturity on debt primarily because preferred dividends are paid before debt interest and are not tax-deductible, resulting in a different cost structure (Damodaran, 2010).

Raising Common Equity: Primary Methods

Firms typically raise common equity through retained earnings and issuing new shares. Since XYZ does not plan to sell new stock, the cost of equity can be estimated using the Capital Asset Pricing Model (CAPM). This approach considers the risk-free rate, the company's beta (systematic risk measure), and the market risk premium, providing a marginal and current estimate of the cost of equity (Brealey, Myers, & Allen, 2020).

Cost of Common Equity using CAPM

Applying the CAPM formula: Cost of Equity = Risk-Free Rate + Beta × Market Risk Premium. With a T-bond yield of 7%, beta of 1.2, and a market risk premium of 6%, the estimated cost of equity is 7% + 1.2 × 6% = 7% + 7.2% = 14.2%. This rate reflects the minimum return demanded by investors for bearing systematic risk associated with XYZ's equity (Fama & French, 2004).

Calculating the WACC

The WACC formula is as follows:

WACC = (E/V) × Re + (D/V) × Rd × (1 − Tc) + (P/V) × Rp

Where:

• E/V = 60% (equity weight)
• D/V = 30% (debt weight)
• P/V = 10% (preferred stock weight)
• Re = 14.2% (cost of equity)
• Rd = 10%, pre-tax, which translates to an after-tax cost of 6% (10% × (1−0.40))
• Rp = 9% (cost of preferred stock)

Plugging in the values:

WACC = 0.60 × 14.2% + 0.30 × 6% + 0.10 × 9% ≈ 8.52% + 1.80% + 0.90% = 11.22%

Thus, XYZ’s estimated WACC is approximately 11.22%, reflecting the overall cost of capital after accounting for taxes, risks, and capital structure proportions (Berk & DeMarzo, 2020).

Conclusion

Estimating XYZ’s WACC requires careful consideration of the sources of capital, their appropriate costs, and the impacts of taxes and flotation costs. By understanding and accurately calculating each component, firms can make informed investment decisions aligned with their strategic financial goals. The application of CAPM for equity, after-tax considerations for debt, and marketplace data ensures that the WACC is both relevant and precise for fiscal planning and valuation purposes.

References

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• Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill Education.
• Damodaran, A. (2010). Applied Corporate Finance. John Wiley & Sons.
• Fama, E. F., & French, K. R. (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives, 18(3), 25-46.
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