Assume that you are the assistant to the CFO of XYZ Company. Your task is to estimate XYZ's WACC using the following data:
The firm's tax rate is 40%.
The current price of the 12% coupon, semiannual payment, non-callable bonds with 15 years to maturity is $1,153.72. New bonds could be issued with no flotation costs.
The current price of the firm's 10% $100 par value, quarterly dividend, perpetual preferred stock is $116.95. The flotation costs on a new issue would be 5% of the proceeds.
The current price of the common stock is $50 per share. The last dividend was $4.19, and dividends are expected to grow at a constant rate of 5%. The firm's beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is 6%.
The target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.
Procedure
What sources of capital should be included when you estimate XYZ's WACC?
Should the component costs be estimated on a before or after-tax basis? Why?
Should the component costs be historical or marginal costs? Why?
What is the market interest rate on XYZ's debt and its component cost of debt?
What is the firm's cost of preferred stock?
Why is the firm's cost of preferred stock lower than the yield to maturity on its debt (Hint: Think about taxes.)
What are the two primary ways that firms raise common equity?
XYZ does not plan to sell common stock. Using the CAPM approach, what is the firm's cost of common equity?
What is the firm's WACC?
To estimate XYZ's WACC (Weighted Average Cost of Capital), you should include the following sources of capital:
1. Long-term debt: This includes the non-callable bonds with 15 years to maturity.
2. Preferred stock: This includes the perpetual preferred stock.
3. Common equity: This includes the common stock.
The component costs should be estimated on an after-tax basis because taxes are deducted from the interest paid on debt and the dividends paid on preferred stock.
The component costs should be estimated on marginal costs rather than historical costs. Marginal costs represent the current cost of raising additional capital, which is more relevant for decision-making. Historical costs may not accurately reflect the current cost of capital.
To determine the market interest rate on XYZ's debt and its component cost of debt, you need to look at the market price of the non-callable bonds. The given price of $1,153.72 indicates the present value of future cash flows from the bonds. By using this price, you can calculate the yield to maturity, which represents the market interest rate. You can convert this yield to maturity to a semi-annual rate, as the bond pays semi-annual coupons.
The cost of preferred stock can be calculated by dividing the annual preferred dividend by the net price after accounting for flotation costs. In this case, the flotation costs are given as 5% of the proceeds from the new issue.
The firm's cost of preferred stock is lower than the yield to maturity on its debt because preferred stock dividends are not tax-deductible, while interest payments on debt are. As a result, the after-tax cost of debt is lower than the cost of preferred stock.
The primary ways that firms raise common equity are through retained earnings (internal equity) and issuing new shares (external equity).
Since XYZ does not plan to sell common stock, the cost of common equity can be estimated using the CAPM (Capital Asset Pricing Model) approach. The formula for the cost of common equity is: Cost of Common Equity = Risk-Free Rate + Beta * Market Risk Premium. Given the risk-free rate of 7%, the market risk premium of 6%, and the beta of 1.2, you can calculate the cost of common equity.
To calculate the firm's WACC, you need to weight the cost of each capital component by its respective target capital structure percentage and then sum them up. In this case, the target capital structure is given as 30% long-term debt, 10% preferred stock, and 60% common equity. Multiply each component cost by its respective weight, and sum them up to get the WACC.
To estimate XYZ's Weighted Average Cost of Capital (WACC), we need to include the following sources of capital:
1. Long-term Debt: This includes the non-callable bonds with 15 years to maturity. Their current market price is $1,153.72. We should use the market interest rate on this debt as the component cost.
2. Preferred Stock: This includes the perpetual preferred stock with a quarterly dividend. Its current market price is $116.95, and the flotation costs on a new issue would be 5% of the proceeds. We need to calculate the component cost of preferred stock.
3. Common Equity: This includes the common stock. Its current market price is $50 per share, and the last dividend was $4.19. Dividends are expected to grow at a constant rate of 5%. We need to calculate the component cost of common equity.
The component costs should be estimated on an after-tax basis because interest on debt and preferred stock dividends are tax deductible, which reduces the company's tax liability.
The component costs should be marginal costs, not historical costs. Marginal costs reflect the current and expected costs of raising new capital, whereas historical costs may not accurately represent the current market conditions.
Now let's calculate the component costs:
1. Cost of Debt:
To find the market interest rate on XYZ's debt, we need to calculate the YTM (Yield to Maturity) of the 12% coupon semiannual payment bonds with 15 years to maturity. Using the bond's current price of $1,153.72, we can use financial calculators or Excel to find the YTM. The YTM represents the market interest rate on the debt.
2. Cost of Preferred Stock:
The cost of preferred stock is the dividend yield, which is the preferred stock dividend divided by the market price of the preferred stock. In this case, the dividend yield is the quarterly dividend divided by the market price of $116.95.
3. Cost of Common Equity:
Using the CAPM (Capital Asset Pricing Model) approach, we can calculate the cost of common equity. The formula is:
Cost of Common Equity = Risk-Free Rate + (Beta * Market Risk Premium)
The risk-free rate is the yield on T-bonds, which is given as 7%. The market risk premium is given as 6%. We need to multiply the company's beta of 1.2 with the market risk premium and add the risk-free rate to get the cost of common equity.
To find the firm's WACC, we need to weight each component cost by its respective percentage in the target capital structure. The formula is:
WACC = (Weight of Debt * Cost of Debt) + (Weight of Preferred Stock * Cost of Preferred Stock) + (Weight of Common Equity * Cost of Common Equity)
Given the target capital structure of 30% long-term debt, 10% preferred stock, and 60% common equity, we can calculate the weights and plug them into the WACC formula to find the firm's WACC.