Question

Johnny Cake Ltd. has 8 million shares of stock outstanding selling at $20 per share and an issue of $40 million in 8 percent annual coupon bonds with a maturity of 16 years, selling at 90.5 percent of par. Assume Johnny Cake’s weighted-average tax rate is 34 percent, its next dividend is expected to be $3 per share, and all future dividends are expected to grow at 4 percent per year, indefinitely.What is its WACC?

Answer 1

Answer:

Year   Cashflow    [email protected]%      PV           [email protected]%     PV

               $                                 $                                  $

  0        (905)           1           (905)           1                 (905)

1-16     52.80         7.8237     413        10.8377           572

16        1,000          0.2176     218      0.4581             458

                                  NPV     (274)              NPV        125                    

Kd = LR     + NPV1/NPV1+NPV2    x (HR – LR)

Kd = 5       + 125/125 + 274   x (10 – 5)

Kd = 5       + 125/399 x 5

Kd = 6.57%    

 

Ke = D1/Po   + g

 Ke = $3/$20 + 0.04

 Ke = 0.19 = 19%

WACC = Ke(E/V) + Kd(D/V)

WACC = 19(160,000,000/196,200,000) + 6.57(36,200,000/196,200,000)

WACC = 15.49 + 1.21

WACC = 16.7%

Market value of the company                                          $

Market value of equity (8,000,000 x $20)                      160,000,000

Market value of bond   ($40,000,000 x $905/$1,000)   36,200,000

Market value of the company                                            196,200,000

Explanation:

In this case, we will calculate cost of debt using interpolation formula. The cashflow for year 0 is the current market price while the cashflow for year 1 to 16 refers to after-tax coupon, which is calculated as R(1-T). R = 8% x $1,000 par value = $80. Then, R(1-T) = 80(1-0.34) = $52.80. The cashflow for year 16 is the par value. The cashflows are discounted in order to obtain the cost of debt.

Cost of equity is the ratio of expected dividend to current market price plus growth rate.

WACC is the aggregate of cost of each capital multiplied by the proportion of each stock in the market value of the company.