Question

Scenario: you work for an investment banking firm and have been asked by management of vestor corporation (not real), a software development company, to calculate its weighted average cost of capital, to use in evaluating a new company investment. the firm is considering a new investment in a warehousing facility, which it believes will generate an internal rate of return of 11.5%. the market value of vestor's capital structure is as follows: source of capital market value bonds $10,000,000 preferred stock $2,000,000 common stock $8,000,000 to finance the investment, vestor has issued 20 year bonds with a $1,000 par value, 6% coupon rate and at a market price of $950. preferred stock paying a $2.50 annual dividend was sold for $25 per share. common stock of vestor is currently selling for $50 per share and has a beta of 1.2. the firm's tax rate is 34%. the expected market return of the s&p 500 is 13% and the 10-year treasury note is currently yielding 3.5%.

Answer 1

Total capital = 10 + 8 + 2 = 20 Million

Weight of bonds (Wd) = 10/20 = 0.5

Weight of preferred stock(Wp) = 2/20 = 0.1

Weight of stock equity(We) = 8/20 = 0.4

Cost of debt = YTM of the bonds issued (We assume its annual coupon)

YTM =rate(nper,pmt,pv,fv) in excel =rate(20,60,-950,1000) = 6.4521%

Cost of debt after tax(Rd) = 6.4521*(1-0.34) = 4.2584%

Cost of preferred shares (Rp) = Preferred dividend/ price = 2.5/25 = 0.10 =10%

Cost of equity (Re) = Rf + beta*(Rm-Rf) = 3.5 + 1.2*(13-3.5) =14.9%

WACC = Wd*Rd + Wp*Rp + We& Re

WACC = 0.5*4.2584% +0.1*10% + 0.4*14.9% = 9.089 = 9.09%