Finance Based On The Information Below Calculate

Finance8financebased On The Information Below Calculate

Running Head Finance8financebased On The Information Below Calculate

8 Finance 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 10%. They had 25-year terms and $1,000 face values. They are now selling to yield 9%. The tax rate is 40% 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 10%. Equity: Great Corp has 120,000 shares of common stock outstanding, currently selling at $14.48 per share. The risk free rate is 3%, market rate of return is 10% and the Beta is 1.2.

Paper For Above instruction

The Weighted Average Cost of Capital (WACC) is a critical metric used by corporations to evaluate their cost of capital, integrating the costs of debt, preferred stock, and equity to measure the average rate of return required by all investors. Accurately calculating WACC provides insight into the company's financial health and its capacity to generate value for shareholders. This paper details the calculation process of WACC for Great Corporation based on the provided financial data, illustrating each component's role and importance.

Introduction

The WACC serves as a benchmark for assessing investment opportunities, strategic decisions, and overall corporate valuation. It reflects the cost that a firm incurs to finance its assets through a mix of debt, equity, and preferred stock. A precise understanding of each component's cost is essential for an accurate WACC calculation, which in turn influences company valuations, capital budgeting, and financial strategy formulation.

Cost of Debt

The debt component involves calculating the effective interest rate that the company pays on its bonds, considering their current market value. Great Corporation's bonds were issued with a 10% coupon rate, a 25-year maturity, and face values of $1,000. Given that these bonds are now trading at a yield of 9%, the effective cost of debt before taxes can be estimated by analyzing the bond's yield to maturity (YTM).

Using approximation methods, because the bond's yield of 9% is close to its coupon rate, the approximate annual interest expense is 10% of $1,000, i.e., $100, but since the bonds are sold at a yield of 9%, the true cost reflects this market-based yield.

The debt's after-tax cost of debt is calculated as:

\(\text{After-tax Cost of Debt} = YTM \times (1 - \text{Tax rate}) = 9\% \times (1 - 0.4) = 5.4\%\)

Cost of Preferred Stock

The preferred stock's dividend rate and market yield determine its cost. Two thousand preferred shares pay an annual dividend of $7.50 each. Initially, these shares sold at a yield of 15% based on a $50 face value, but the current yield is 10%, and the current market price can be derived from this yield.

The dividend per share remains at $7.50, and the current market price \(P_{0}\) can be estimated as:

\( P_{0} = \frac{\text{Dividend}}{\text{Yield}} = \frac{7.50}{0.10} = \$75 \)

Thus, the cost of preferred stock (dividend yield) is:

\(\text{Cost of Preferred} = \frac{\text{Dividend}}{\text{Market Price}} = \frac{7.50}{75} = 10\%\)

Cost of Equity

The cost of equity can be estimated using the Capital Asset Pricing Model (CAPM), which incorporates the risk-free rate, the market risk premium, and the company's Beta:

\( \text{Cost of Equity} = R_f + \beta \times (R_m - R_f) \)

Where:

  • \( R_f = 3\% \) (risk-free rate)
  • \( R_m = 10\% \) (market rate of return)
  • \( \beta = 1.2 \) (Beta)

Substituting the values:

\( \text{Cost of Equity} = 3\% + 1.2 \times (10\% - 3\%) = 3\% + 1.2 \times 7\% = 3\% + 8.4\% = 11.4\%\)

Determining Capital Structure Weights

Next, the relative proportions of debt, preferred stock, and equity in the company's capital structure are calculated based on market values.

Debt: The bonds' market value is given as their yield, but for simplicity, we assume the current market value is close to the face value adjusted for the yield. Since the bonds are trading at a yield of 9%, the market value per bond roughly equals:

\( \text{Price} = \text{Face value} \times \frac{\text{Coupon rate}}{\text{Yield}} = 1000 \times \frac{10\%}{9\%} \approx \$1,111.11 \)

The total debt market value:

\( 1,000 \text{ bonds} \times \$1,111.11 = \$1,111,110 \)

Preferred Stock: The current market value of preferred stock is:

\( 2,000 \text{ shares} \times \$75 = \$150,000 \)

Equity: The market value of equity is:

\( 120,000 \text{ shares} \times \$14.48 = \$1,737,600 \)

The total market value of the firm's capital is:

\( \$1,111,110 + \$150,000 + \$1,737,600 = \$2,998,710 \)

Calculating WACC

The weights for each component are:

  • Weight of Debt \(w_d = \frac{\$1,111,110}{\$2,998,710} ≈ 0.370\)
  • Weight of Preferred Stock \(w_{ps} = \frac{\$150,000}{\$2,998,710} ≈ 0.050\)
  • Weight of Equity \(w_e = \frac{\$1,737,600}{\$2,998,710} ≈ 0.580\)

The WACC formula is:

\[ \text{WACC} = w_d \times \text{After-tax Cost of Debt} + w_{ps} \times \text{Cost of Preferred} + w_e \times \text{Cost of Equity} \]

Substituting the values:

\[ \text{WACC} = 0.370 \times 5.4\% + 0.050 \times 10\% + 0.580 \times 11.4\% \]

\[ \text{WACC} ≈ 2.00\% + 0.50\% + 6.61\% ≈ 9.11\% \]

Therefore, the Weighted Average Cost of Capital for Great Corporation is approximately 9.11%.

Conclusion

The calculation of Great Corporation's WACC reveals a figure of approximately 9.11%, reflecting the company's cost structure and market conditions. Understanding this metric aids managerial decisions regarding financing strategies, investment opportunities, and valuation assessments. Properly accounting for the costs associated with debt, preferred stock, and equity ensures more accurate financial planning and valuation models.

References

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  • Van Horne, J. C., & Wachowicz, J. M. (2008). Fundamentals of Financial Management (13th ed.). Pearson Education.
  • Ross, S. A., Westerfield, R. W., & Jaffe, J. (2019). Corporate Finance (12th ed.). McGraw-Hill Education.
  • Fridson, M., & Alvarez, F. (2011). Financial Statement Analysis: A Practitioner's Guide (4th ed.). Wiley.
  • Investopedia. (2023). Weighted Average Cost of Capital (WACC). https://www.investopedia.com/terms/w/wacc.asp
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  • Graham, J., & Harvey, C. (2001). The Effect of Managerial Incentives on Firm Investment. Journal of Financial Economics, 60(2-3), 185-212.

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