Question

Vandelay Industries has a target capital structure consisting of 40% debt, 5% preferred stock, and 55% common equity. Vandelay has 20-year, 11% semiannual coupon bonds that sell at their par value of $1,000. The component cost of preferred stock is 12.4%. Vandelay is a constant growth firm that recently paid a dividend of $2.05, sells for $27.00 per share, and has a growth rate of 7%. Flotation costs on new common stock are 10%, and the firm's marginal tax rate is 25%. What is Vandelay Industries’ WACC assuming they will have to use internal equity?
a. 13%
b. 12.24%
c. 12.74%
d. none of these choices

Answer 1

Answer:

b. 12.24%

Explanation:

The computation is shown below;

The cost of debt  is 11%

As when the bonds would be sell at par value so yield to maturity = coupon rate = cost of debt i.e. 11%

Now  

cost of equity= ((Do × (1+g)) ÷ P)+g  

= (($2.05 × (1 + 7%)) ÷ 27) + 7

= 15.12%

Now

WACC = weight of equity × cost of equity + weight of preferred equity × cost of equity + weight of debt × cost of debt × (1 - tax rate)

= 55% × 15.12% + 5% ×12.4% + 40% × 11% × (1 - 25%)

= 12.24%