Wednesday, January 4, 2012

Preferred Stock and WACC

Preferred Stock and WACC – The Saunders Investment Bank has the following financing outstanding. What is the WACC for the company?
Debt:                40,000 bonds with a 7 percent coupon rate and a current price quote of 119,80; the bonds  have 25 years to maturity . 15,000 zero coupon bonds with a price quote of 18,2 and 30 years until maturity.
Preferred stock:  100,000 shares of 4 percent preferred stock with a current price of $78, and a par value = $100.
Common stock:   1,800,000 shares of common stock; the current price is $65, and the beta of the stock is 1,1.
Market:              the corporate tax rate is 40 percent, the market risk premium is 7 percent, and the risk – free rate is 4 percent.

MVD1 = 40,000 ($1,000)(1.198) = $47,920,000
MVD2  = 15,000 ($1,000) (1.82) = $27,300,000
MVP = 100,000 ($78) = $7,800,000
MVE = 1,800,000 ($65) = $117,000,000

And the total market value of the firm is:

V = $47,920,000 + $27,300,000 +$7,800,000 +$117,000,000 = $200,020,000
Now, we can find the cost of equity using the CAPM. The cost of equity is:
Rs = RF + β (RM – RF)
= 0.04 + 1.1 (0.07)
= 0.117 = 11.7%

The cost of debt is the YTM of the bonds, so:
P0 = 1.198 = $35 (1 – 1/(1+r)t / r) + $1,000 (1/(1+r)t
R = 0.028
YTM = 0.0553

And the after tax cost of debt:
RD1 = (1 – 0.4) (0.0553) = 0.0332 = 3.32%

And the after tax zero coupon bonds is:

P0 = $182 = $1000 (PVIFR%, 60)
R = 2.880%
YTM = 2 x 2.880% = 5.76%

RD2 = (1 – 0.4) (0.0576) = 0.0346 = 3.456%

To find the required return on preferred stock,
RP = D1 / P0
RP =
Rp =

The WACC is:

WACC = 0.0332(47.92/200.02) + 0.0356 (27.3/200.02) + 0.117 (117/200.02) + 0.0513 (7.8/200.02)
WACC = 

Reference: Corporate Finance Book, Stephen A.Ross, Randolph W.Westerfield and Jeffrey Jaffe, Ninth Edition. Chapter 13, questions and problems  number 19 page 424.

5 comments:

Anonymous said...

Where does the 35$ come from?

selviautama said...

C=7% - for annual payment. Since the payment is semi annually:
C=7%/2 = 3,5%

Coupon = 3,5% x par value
=3,5% x $1000
=$35

Anonymous said...

Where does "the payment is semi annually" come from?

selviautama said...

In this exercise, we just assumed with semi annually payment.

David BOUHANA said...

MVD1 = 40,000 ($1,000)(1.198) = $47,920,000 -- where does the 1000 come from ?

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