Question

Lipscomb Corporation is estimating its WACC. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for 1,000 USD. The firm could sell, at par, 100 USD preferred stock which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Libscomb is a constant-growth firm which just paid a dividend of $2.00, sells for 27.00 USD per share, and has a growth rate of 8 percent. The firm's marginal tax rate is 40 percent.
Required:
Calculate the WACC.

Answer 1

Answer: 13.57%

Explanation:

Weighted Average Cost of Capital (WACC) as implied, takes a weighted average of the various costs of acquiring capital in the form of equity and loans.

Cost of Preferred stock:

= Dividend / Floatation adjusted price

= (0.12 * 100) / (100 * (1 - 5%))

= 12 / 95

= 12.63%

Cost of debt:

Bond is selling at $1,000 which is par value. This means that Coupon rate of 12% is also Yield.

Yield has to be adjusted for tax as interest is tax deductible:

= 12% * ( 1 - 40%)

= 7.2%

Cost of Common Equity:

Price = Next dividend / (Cost - growth rate)

27 = (2 * (1 + 8%)) / (Cost - 8%)

(Cost - 8%) * 27 = 2.16

Cost - 8% = 2.16 / 27

Cost = 8% + 8%

Cost = 16%

WACC = Weight of debt * After tax cost of debt + Weight of Preferred stock * Cost of preferred stock + Weight of Common stock * Cost of common stock

= 20% * 7.2% + 20% * 12.63% + 60% * 16%

= 13.57%