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Principles of Finance (FIN 3213)

Weighted Average Cost of Capital (WACC)

Homework #18 (10 points) due 2:00 p.m., Tuesday 11/10/2020

Problem #1.

ABC Industries is considering expanding their facilities. As part of the decision process, ABC is calculating its weighted average cost of capital (WACC). Your assignment is to calculate the companys WACC based on the following information:

Rd=YTM=Cost of debt

FV= 1000 par

PMT=1000par*.064= 64/2(semi)= 32

N=15years*2(semi)=30

PV=CMP 1070 15(Floatation)=1055

CPT I/Y= 2.92%*2(Semi) = 5.84% = Rd

Rps=Div/Price(Net of flotation)= Cost of pref stock

Div=100par*4.4%yr = $4.4

Price= 86 2 (flotation) = 84

Rps= 4.4 / 86 = 0.51 0r 5.1%

Rce=(D1/Price)+G=Cost of common equity

D1= 3.80

Price=(P-float)= 76.50 * 0.08(flotation)=$6.12, 76.50 6.12 = 70.38

Rce= (3.80 / 70.38) + 0.025(semi) = 0.079*2(semi) = 15.8% or 0.158

WACC=Wd Rd (1-T)+ Wps Rps + Wce Rce

Wd=Proportion of TCap in form of debtBonds/TCap=1501/5304(Add 5 CL)=0.283

Rd= 0.0584

1-T= (1-0.22)

Wps=ps/TCap=425/5304= 0.08

Rps= 0.051

Wce=(CS+PIC+RE)/TCap=(100+705+2573)/5304 = 0.63688

Rce= 0.158

WACC=(0.283)(0.0584)(1-0.22)+(0.08)(0.051)+(0.63688)(0.158)=0.1176 or 11.76%

1. The firms tax rate is 22%.

2. The current market price of ABCs outstanding bonds is 107% of their $1,000 par value. The bonds have an annual coupon rate of 6.4% and make coupon payments semiannually. The bonds mature in 15 years. New bonds will have a flotation cost of $15 per bond.

3. The current price of the firms preferred stock is $86.00 per share. The stock has a $100 par value and a 4.4% annual dividend rate (paid annually). Flotation costs on new preferred stock are expected to be $2.00 per share.

4. The current price of the firms common stock is $76.50 per share. Its next (upcoming) semiannual dividend will be D₁ = $3.80 per share. Dividends are paid semiannually and are expected to grow at an annual rate of 5% into the foreseeable future. The flotation cost for newly-issued common stock is 8%. NOTE that $3.80 is the amount of the semiannual dividend. It does not need to be divided by two.

2020 Balance Sheet (thousands of dollars)

cash 95 accounts payable 200

accounts receivable 335 notes payable 250

inventory 369 accruals 101

current assets 799 current liabilities 551

gross fixed assets 6056 long-term debt (bonds) 1501

accum. depreciation 1000 preferred stock 425

net fixed assets 5056 common stock 100

total assets 5855 paid-in capital 705

retained earnings 2573

total common equity 3378

total liabilities and equity 5855

Problem #2.

Refer to the information concerning ABC Industries in problem #1. In discussions with the companys CEO, you learn that a decision has been made to eliminate future dividends on the companys common stock. This means that, since your estimate of the cost of common equity was based on the Discounted Cash Flow Methods and a forecast of future dividend payments, your previous estimate of WACC is incorrect.

It will be necessary to recalculate the cost of common equity using the Capital Asset Pricing Model (CAPM). Research shows you the following:

Risk free rate R_f 3.6% per year (T-bill proxy)

Expected market return E(R_M) 11% per year (S&P 500 proxy).

Further, the beta for the company is:

_ABC +2.83.

A. Use the CAPM to estimate the companys cost of common equity.

Required Rate of Return = Risk-free Rate + beta * (Market Return - Risk-free Rate)

= 0.036 + 2.83 * (0.11-0.036) = -0.03475 = Rce

B. Recalculate the companys WACC using the new estimate of cost of common equity. NOTE: do not include the common equity flotation cost.

WACC=Wd Rd (1-T)+ Wps Rps + Wce Rce

WACC=(0.283)(0.0584)(1-0.22)+(0.08)(0.051)+(0.63688)(-0.03475)=-0.00516 or -0.516%