Assume that you are the assistant to the CFO of XYZ Company. Your task is to estimate XYZ's WACC using the following data:
1.The firm's tax rate is 40%.
2.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.
3.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.
4.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%.
5.The target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.
Procedure
1.What sources of capital should be included when you estimate XYZ's WACC?
2.Should the component costs be estimated on a before or after-tax basis? Why?
3.Should the component costs be historical or marginal costs? Why?
4.What is the market interest rate on XYZ's debt and its component cost of debt?
5.What is the firm's cost of preferred stock?
6.Why is the firm's cost of preferred stock lower than the yield to maturity on its debt (Hint: Think about taxes.)
7.What are the two primary ways that firms raise common equity?
8.XYZ does not plan to sell common stock. Using the CAPM approach, what is the firm's cost of common equity?
9.What is the firm's WACC?
1. When estimating XYZ's WACC, the sources of capital that should be included are long-term debt, preferred stock, and common equity. These are the three main sources of financing for a company and they represent the different types of capital that the company relies on.
2. The component costs should be estimated on an after-tax basis. This is because the interest paid on debt is tax-deductible, which reduces the overall cost of debt for the company. By estimating the component costs on an after-tax basis, we can accurately reflect the tax benefits that result from interest expense.
3. The component costs should be marginal costs rather than historical costs. Marginal costs represent the current and relevant costs of capital to the company. Marginal costs take into account the current market conditions and reflect the costs that the company would incur if it were to raise capital today.
4. The market interest rate on XYZ's debt can be determined by calculating the yield to maturity of the bonds. In this case, the current price of the bonds is given, which is $1,153.72. By using financial calculators or spreadsheets, we can calculate the yield to maturity, which represents the market interest rate on the debt. The component cost of debt is equal to the pre-tax cost of debt, as it is not affected by taxes.
5. The firm's cost of preferred stock can be calculated by dividing the annual dividend by the price of the preferred stock. In this case, the annual dividend is 10% of the par value of $100, which is $10. Therefore, the cost of preferred stock is $10 divided by the current price of $116.95.
6. 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, whereas interest on debt is tax-deductible. Therefore, the after-tax cost of preferred stock is higher than the after-tax cost of debt, making the cost of preferred stock lower on a pre-tax basis.
7. The two primary ways that firms raise common equity are through retained earnings, which are profits that are reinvested into the company, and issuing new common stock. Retained earnings do not have any direct costs associated with them, as they represent funds that the company already has. However, issuing new common stock may incur costs, such as underwriting fees and flotation costs.
8. Since XYZ does not plan to sell common stock, the cost of common equity can be calculated using the Capital Asset Pricing Model (CAPM). The CAPM formula is: Cost of Equity = Risk-Free Rate + Beta * Market Risk Premium. In this case, the risk-free rate is given as 7%, the beta is 1.2, and the market risk premium is 6%. By plugging these values into the formula, we can calculate the cost of common equity.
9. The firm's WACC can be calculated by weighting the costs of each capital component based on their target proportions in the company's capital structure. In this case, the target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity. By multiplying each component cost by its respective weight and summing them, we can calculate the WACC for XYZ.