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.

MV_D1 = 40,000 ($1,000)(1.198) = $47,920,000

MV_D2  = 15,000 ($1,000) (1.82) = $27,300,000

MV_P = 100,000 ($78) = $7,800,000

MV_E = 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:

R_s = R_F + β (R_M – R_F)

= 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:

R_D1 = (1 – 0.4) (0.0553) = 0.0332 = 3.32%

And the after tax zero coupon bonds is:

P₀ = $182 = $1000 (PVIF_{R%, 60})

R = 2.880%

YTM = 2 x 2.880% = 5.76%

R_D2 = (1 – 0.4) (0.0576) = 0.0346 = 3.456%

To find the required return on preferred stock,

R_P = D₁ / P₀

R_P =

R_p =

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.

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