Calculate The Weighted Average Based On The Information Belo

Based On The Information Below Calculate The Weighted Average Cost

1. Based on the information below, calculate the weighted average cost of capital. Great Corporation has the following capital situation. Debt: One thousand bonds were issued five years ago at a coupon rate of 8%. They had 25-year terms and $1,000 face values. They are now selling to yield 9%. The tax rate is 36% Preferred stock: Two thousand shares of preferred are outstanding, each of which pays an annual dividend of $7.50. They originally sold to yield 15% of their $50 face value. They're now selling to yield 8%. Equity: Great Corp has 125,000 shares of common stock outstanding, currently selling at $14.48 per share. Dividend expected for next year is $1.00 and the growth rate is 5%.

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Calculating the weighted average cost of capital (WACC) is a fundamental task for financial managers, as it provides a measure of the average rate that a company is expected to pay to finance its assets through a mix of debt, preferred stock, and equity. Accurately computing WACC involves determining the costs associated with each capital component, adjusting for their proportion in the overall capital structure, and incorporating tax effects where applicable. In this analysis, we examine Great Corporation’s capitalization to determine its weighted average cost of capital based on provided data about its debt, preferred stock, and equity.

Cost of Debt (Kd)

The debt of Great Corporation consists of bonds issued five years ago with a face value of $1,000, a coupon rate of 8%, and a remaining maturity of 20 years (since the original 25-year term was issued five years prior). These bonds are currently selling at a yield of 9%. The yield to maturity (YTM) effectively represents the cost of debt before tax considerations. Therefore, the cost of debt (YTM) is 9%. Since interest expense on debt is tax-deductible, the after-tax cost of debt is calculated as:

After-tax cost of debt = YTM × (1 – Tax rate)

Thus,

After-tax Kd = 9% × (1 – 0.36) = 9% × 0.64 = 5.76%

Cost of Preferred Stock (Kp)

The preferred stock pays an annual dividend of $7.50 per share. Although initially issued at a yield of 15% based on a $50 face value, current yields suggest a different valuation context. The preferred stock is now selling at a yield of 8%. To find the current price per share, we use the dividend discount model for preferred stock:

Price = Dividend / Yield

Therefore,

Price = $7.50 / 8% = $7.50 / 0.08 = $93.75

The cost of preferred stock (Kp) is then:

Kp = Dividend / Price = $7.50 / $93.75 ≈ 8.00%

Cost of Equity (Ke)

Great Corporation’s common stock is currently trading at $14.48 per share. The company expects a dividend of $1.00 next year, with dividends growing at a rate of 5%. The dividend growth model (also known as the Gordon Growth Model) is applied here to estimate the cost of equity:

Ke = (Dividend / Price) + Growth Rate

Calculating,

Ke = ($1.00 / $14.48) + 0.05 ≈ 0.069 + 0.05 = 0.119 or 11.9%

Weightings in the Capital Structure

The weights of each component are based on their market values relative to the total capital.

• Debt: Number of bonds = 1,000; face value per bond = $1,000; total market value of debt = 1,000 × $1,000 = $1,000,000 (since bonds are trading at a yield of 9%, approximate market value aligns with face value).
• Preferred stock: Number of shares outstanding = 2,000; price per share ≈ $93.75; total preferred value = 2,000 × $93.75 = $187,500.
• Equity: Shares outstanding = 125,000; price per share = $14.48; total equity value = 125,000 × $14.48 = $1,810,000.

Market values summing up:

Total capital = $1,000,000 + $187,500 + $1,810,000 = $2,997,500.

Calculating WACC

The WACC formula is:

WACC = (E / V) × Ke + (P / V) × Kp + (D / V) × Kd (after-tax)

where E = equity market value, P = preferred stock value, D = debt market value, and V = total capital.

Calculations:

• Weight of Equity (E / V) = $1,810,000 / $2,997,500 ≈ 0.603
• Weight of Preferred Stock (P / V) = $187,500 / $2,997,500 ≈ 0.063
• Weight of Debt (D / V) = $1,000,000 / $2,997,500 ≈ 0.334

Putting these together, the WACC is:

WACC = 0.603 × 11.9% + 0.063 × 8.00% + 0.334 × 5.76%

Calculating each term:

0.603 × 11.9% ≈ 7.17%

0.063 × 8.00% ≈ 0.50%

0.334 × 5.76% ≈ 1.93%

Adding these gives the overall WACC:

WACC ≈ 7.17% + 0.50% + 1.93% ≈ 9.60%

This WACC reflects the company's average cost of capital, considering its capital structure and the respective costs of each component adjusted for taxes in the case of debt.

Conclusion

In conclusion, Great Corporation’s weighted average cost of capital is approximately 9.60%. This comprehensive measure provides critical insight into the expected return required by investors across all financing sources, serving as a vital benchmark for investment and operational decisions. Accurate WACC calculation allows the company to evaluate project viability, optimize capital structure, and ensure strategic financial planning aligned with shareholder value maximization. Regular updates of WACC calculations are essential as market conditions, risk perceptions, and capital structures evolve over time, ensuring ongoing financial health and competitiveness.

References

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