Question

Bonus Question: Assume the market value of Fords' equity, preferred stock and debt are $7 billion, $4 billion and $10 billion respectively. Ford has a beta of 1.4, the market risk premium is 6% and the risk-free rate of interest is 4%. Ford's preferred stock pays a dividend of $3 each year and trades at a price of $25 per share. Ford's debt trades with a yield to maturity of 8.5%. What is Ford's weighted average cost of capital if its tax rate is 35%?

Answer 1

Answer:

7.13%

Explanation:

WACC is the average cost of capital of the firm based on the weightage of the debt and weightage of the equity multiplied to their respective costs.

Formula for WACC

Weighted Average Cost of Capital = (Cost of Equity x Weightage of equity) + (Cost of preferred Stock x Weightage of preferred Stock ) + (Cost of Debt (1 -t) x Weightage of Debt)

Weightage

Total Value =  $7 billion + $4 billion + $10 billion =  $21 billion

Equity = $7 billion / $21 billion

Preferred = $4 billion / $21 billion

Debt  = $10 billion / $21 billion

Cost of Equity :

We can calculate cost of equity using CAPM

Capital asset pricing model measure the expected return on an asset or investment. it is used to make decision for addition of specific investment in a well diversified portfolio.

Formula for CAPM

Cost of Equity = Risk free rate + beta ( market return - risk free rate )

Cost of Equity = Rf + β ( Rm - Rf )

Cost of Equity = 4% + 1.4 ( 6% )

Cost of Equity = 12.4%

Cost of Preferred stock = $3/$100 = 3% (assuming the preferred stock par value is $100)

Cost of Debt = 8.5%

Placing values in the formula

Weighted Average Cost of Capital = (12.4% x $7 billion / $21 billion) + (3% x $4 billion / $21 billion ) + (8.5% (1 - 0.4) x $10 billion / $21 billion)

Weighted Average Cost of Capital = 4.13% + 0.57% + 2.43% = 7.13%