Lecture 14 WACC Calculation

Topic covered in this lecture Numerical example Variables needed to calculate WACC Cost of debt Cost of equity Cost of preferred equity Market value capital structure weights WACC Practice question

Numerical Example # shares = 100,000 Dividend per share = $1.5 Debt # bonds = 5,000 Coupon rate = 8% per annum Payments = Semi-annual Face value = $1,000 Bond price = $976.87 Time to maturity = 6 years Common Equity # shares outstanding = 2,000,000 Price per share = $2.50 Beta = 1.5 Risk-free rate = 3% Market return = 7% Preferred Equity # shares = 100,000 Dividend per share = $1.5 Price per share = $10.50

Variables needed to calculate WACC WACC = wCSRCS + wPSRPS + wDRD(1 – T) To use this formula, we will need the following data: wCS = capital structure weight on common equity wPS = capital structure weight on preferred equity wD = capital structure weight on debt RCS = cost of capital on common equity RPS = cost of capital on preferred equity RD = cost of capital on debt T = marginal corporate tax rate

Cost of Debt # bonds = 5,000 Coupon rate = 8% per annum Payments = Semi-annual Face value = $1,000 Bond price = $976.87 Time to maturity = 6 years Coupon payment = 0.08 x $1,000 / 2 = $40 Number of coupon payments remaining = 6 x 2 = 12 PMT = -40 FV = -1000 PV = 976.87 N = 12 COMP I/Y Cost of debt = Bond yield = RD = 0.0425 x 2 = 0.085 = =8.5%

Cost of Common Equity # shares outstanding = 2,000,000 Price per share = $2.50 Beta = 1.5 Risk-free rate = Rf = 3% Market return E(Rm) = 7% Using SML, we have RCS = Rf + Beta(E(Rm) – Rf) = 0.03 + 1.5(0.07 – 0.03) = 0.09 Cost of common equity = RCS = 0.09 = 9%

Cost of Preferred Equity # shares = 100,000 Dividend per share = $1.5 Price per share = $10.50 Cost of preferred equity = preferred equity yield = RPS = Dividend per share / Price per share = 1.5/10.5 = 0.14285714 = 14.285714%

Capital Structure Weights Weight on financing i = MV(financing i) / MV(Total Assets) Market value of debt = MV(Debt) = Bond price x # bonds = $976.87 x 5,000 = $4,884,348.71 Market value of common equity = MV(Common Equity) = Share price x # shares = $2.50 x 2,000,000 = $5,000,000 Market value of preferred equity = MV(Preferred Equity) = Preferred share price x # preferred shares = $10.50 x 100,000 = $1,050,000

Capital Structure Weights (cont.) MV(Total Assets) = MV(Debt) + MV(Common equity) + MV(Preferred equity) = $4,884,348.71 + $5,000,000 + $1,050,000 = $10,934,348.71 Weight on Debt = MV(Debt) / MV(Total Assets) = $4,884,348.71 / $10,934,348.71 = 0.44669773 Weight on Common Equity = MV(Common Equity) / MV(Total Assets) = $5,000,000 / $10,934,348.71 = 0.45727461 Weight on Preferred Equity = MV(Preferred Equity) / MV(Total Assets) = $1,050,000 / $10,934,348.71 = 0.09602767

WACC = wCSRCS + wPSRPS + wDRD(1 – T) WACC = (0.45727461 x 0.09) + (0.09602767x 0.14285714) + (0.44669773 x 0.085 x (1 – 0.4)) = 0.04115471 + 0.01371824 + 0.02278184 = 0.07765479 = 7.765479%

Three Cheers for Practice Hip Hip Hurray! ABC, Inc.’s capital structure is made up of debt, common equity and preferred equity. The company has 10,000 coupon bonds outstanding, each with a maturity of 10 years, face value of $1,000, and a coupon rate of 6%. Coupons are paid quarterly but interest is compounded semi-annually. The yield on this bond issue is 5.5%. There are 1 million common shares outstanding, each at a price of $6.00. The beta on these common shares is 0.9, the risk-free rate is 2% and the expected market return is 8%. There are 50,000 preferred shares outstanding. The preferred shares pay a constant dividend of $1.00 and has an estimated yield of 6.25%. If the marginal corporate tax rate is 35%, what is ABC’s WACC?

Check Answers Cost of debt = RD = 0.055 Cost of common equity = RCS = Rf + Beta(Rm – Rf) = 0.02 + 0.9(0.08 – 0.02) = 0.074 Cost of preferred equity = RPS = 0.0625 MV(Debt) = $1,041.187451 x 10,000 = $10,411,874.51 MV(Common Equity) = $6 x 1,000,000 = $6,000,000 MV(Preferred Equity) = $16 x 50,000 = $800,000 MV(Total Assets) = $17,211.874.51 wD = 0.60492392 wCS = 0.34859655 wPS = 0.04647954 WACC = 0.05032715 = 5.03%

End of Lesson 14 on WACC Calculation