Question

Aaron's Rentals has 58,000 shares of common stock outstanding at a market price of $36 a share. The common stock just paid a $1.64 annual dividend and has a dividend growth rate of 2.8 %. There are 12,000 shares of 6 % preferred stock outstanding at a market price of $51 a share. Preferred stock pays a dividend of $6 a year The outstanding bonds mature in 17 years, have a total face value of $750,000, a face value per bond of $1,000, and a market price of $1,011 each. The bonds pay 8 % interest, semiannually. The tax rate is 34 %. What is the firm's weighted average cost of capital

Answer 1

Answer:

The firm's weighted average cost of capital (WACC) is 7.76%.

Explanation:

Note: Par value of the preferred stock is $100 but it is omitted in the question.

Market price share = (Dividend just paid (1 + Dividend growth rate)) / (Cost of equity – Dividend growth rate) ………………………………….. (1)

Substituting the relevant values into equation and solve for cost of equity, we have:

36 = (1.64 * (1 + 0.028)) / (Cost of equity – 0.028)

36 = 1.68592/ (Cost of equity – 0.028)

36(Cost of equity – 0.028) = 1.68592

36Cost of equity - 1.008 = 1.68592

36Cost of equity = 11.68592 + 1.008

Cost of equity = (1.68592 + 1.008) / 36

Cost of equity = 0.0748, or 7.48%

Cost of preferred stock = (Par value * Dividend rate) / Current price = (100 * 6%) / 51 = 0.1176, or 11.76%

Cost of debt = Coupon rate * (100% - tax rate) = 8% * (100% - 34%) = 0.0528, or 5.28%

Common stock market value = 58,000 * $36 = $2,088,000

Preferred market value = 12,000 * $51 = $612,000

Bond market value = $750,000 * ($1,011 / $1,000) = $758,250

Total market value of the company = Common stock market value + Preferred market value + Bond market value = $2,088,000 + $612,000 + $758,250 = $3,458,250

WACC = (7.48% * ($2,088,000 / $3,458,250)) + (11.76% * (612,000 / $3,458,250)) + (5.28% * ($758,250/ $3,458,250)) = 0.0776, or 7.76%