Burton currently has $850,000 of long-term debt outstanding, 5,000 shares of preferred stock ($10 par) with a market price of $13, and 20,000 shares of common stock ($20 par) with a market price of $54 per share. they have used a wacc of 14% in the past to evaluate projects but want to determine their current required return for new investments.

debt: burton can sell a 10-year, $1,000 par value, 8 percent annual coupon bond for $980. a flotation cost of 2 percent of the face (par) value would be required. additionally, the firm has a marginal tax rate of 21 percent. preferred stock: burton pays $1.25 dividends annually on their preferred shares.

the shares are currently selling for $13 in the secondary market. they do not have plans to issue any additional preferred stock. common stock: burton's common stock is currently selling for $54 per share. the dividend expected to be paid at the end of the coming year is $4. its dividend payments have been growing at a constant 4% rate.

calculate the after-tax cost of debt
calculate the cost of preferred equity
calculate the cost of common equity
calculate the wacc

The cost of debt is 8%

The cost of preference shares is 9.6%

the Cost of equity is 11.4%

The WACC is approximately 9.2%

Explanation:

The cost of debt is the interest rate on the debt which is 8%

The cost of preference shares is 9.6% calculated as pref share divided/market value of preference shares x 100% (1.25/13) x 100%

The Cost of equity is 11.4% calculated as: dividend/market value + growth rate which is (4/54)+4%.

The WACC is a proportionate computation of the cost of capital using each component of the capital structure as a numerator of the total market value of the capital structure taking into account the floatation rate  of of 2% in  the debt, and the marginal tax rate of 21%.

Given the above, the component of capital and the associated costs are as follows:

Component                      Market ValueCost of capital

Debt                                   833,000.00*  8.0%

Preference shares                     65,000.00  9.6%

Equity                                     1,080,000.00  11.4%

Total                                           1,978,000.00  

* it is assumed that the debt holding has been reduced by 2% flotation costs.

The WACC is (debt/total)x kd x (1-21%) + (pref shares/total) x kpf + (equity/total) x ke

= (833,000/1,978,000) x 8% x (1-21%) + (65,000/1,978,000) x 9.6% + (1,080,000/1,978,000) x 11.4% = 9.2%.

Explanation:

Year   Cashflow    [email protected]%      PV           [email protected]%     PV

               $                                 $                                  $

  0     (960.4)           1           (960.4)               1            (960.4)

1-10    63.2             6.1446    388             7.7217          488

10       1,000          0.3855     386          0.6139            614

                                  NPV      (186)              NPV         142                    

Kd = LR     + NPV1/NPV1+NPV2    x (HR – LR)

Kd = 5       + 142/142 + 186  x (10 – 5)

Kd = 5       + 142/328 x 5

Kd = 7.16%    

b. Kp = D/Po

   Kp = $1.25/$13

  Kp = 0.096 = 9.6%

c. Ke = D1/Po   + g

  Ke = $4/$54 + 0.04

  Ke = $4/$54 + 0.04

 Ke = 0.1141 = 11.41%

d. WACC = Kd(D/V)(1 – T)  + Kp(P/V) + Ke(D/V)

WACC = 7.16($816,340/$1,961,340) + 9.6($65,000/$1,961,340) + 11.41($1,080,000/$1,961,340)

WACC = 2.98 + 0.32 + 6.28

WACC = 3.58%    

Market value of the firm:                                               $

Market value of debt ($850,000 x $960.4/$1,000  = 816,340

Market value of preferred stocks (5,000 x $13)        = 65,000

Market value of common stock (20,000 x $54)        = 1,080,000

Market value of the firm                                                1,961,340

Explanation:

In this case, we need to calculate the after-tax cost of debt. The current market price of the bond less floatation cost is the cashflow for year 0 (980 - 19.6 = 960.4). The after-tax coupon on the bond is the cashflow for year 1-10. The after-tax coupon is calculated as R(1-T), which is equal to 80(1-0.21) = $63.2. The cashflow for year 10 is the par value. Then, we will discount the cashflows for 10 years. Thus, we will apply internal rate of return formula to determine the cost of bond.

Cost of preferred stocks is equal to dividend paid divided by the current market price.

Cost of common stock is equal to expected dividend divided by the current market price plus growth rate.

WACC is calculated by considering the cost of each stock multiplied by the proportion of each stock to the market value of the company.

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