Problem 14-15 Finding the WACC (LO4)

You are given the following information for Magrath Power Co. Assume the company’s tax rate is
35%.
 
Debt: 10,000 6.4% coupon bonds outstanding, $1,000 par value, 25 years to maturity, selling for
108% of par; the bonds make semiannual payments.
Common stock: 495,000 shares outstanding, selling for $63 per share; the beta is 1.15.
Preferred stock: 35,000 shares of 3.5% preferred stock outstanding, currently selling for $72 per
share.
Market: 7% market risk premium and 3.2% risk-free rate.
 
What is the company's WACC? (Do not round intermediate calculations. Enter your answer as
a percentage rounded to 2 decimal places.)
 
9.07
WACC              %

 
Explanation:
We will begin by finding the market value of each type of financing. We find:
 
MVD = 10,000($1,000)(1.08) = $10,800,000
MVE = 495,000($63) = $31,185,000
MVP = 35,000($72) = $2,520,000
 
And the total market value of the firm is:
 
V = $10,800,000 + $31,185,000 + $2,520,000
V = $44,505,000
 
Now, we can find the cost of equity using the CAPM. The cost of equity is:
 
RE = 0.032 + 1.15 (0.07)
RE = 0.1125, or 11.25%
 
The cost of debt is the YTM of the bonds, so:
 
P0 = $1,080 = $32(PVIFAR%,50) + $1,000(PVIFR%,50)
R = 2.895%
YTM = 2.895% × 2 = 5.790%
 
And the after-tax cost of debt is:
 
RD = (1 – 0.35)(0.0579)
RD = 0.037635, or 3.764%
 
The cost of preferred stock is:
 
RP = $3.50 / $72
RP = 0.04861, or 4.861%
 
Now we have all of the components to calculate the WACC. The WACC is:
WACC = 0.03764 ($10,800,000 / $44,505,000) + 0.1125 ($31,185,000 / $44,505,000) + 0.04861
($2,520,000 / $44,505,000)
WACC = 0.0907, or 9.07%
 
Notice that we didn’t include the (1 – tC) term in the WACC equation. We used the after-tax cost
of debt in the equation, so the term is not needed here.
References
Problem 14-16 Finding the WACC (LO4)
Raymond Mining Corporation has 8.5 million shares of common stock outstanding, 250,000 shares
of 5% $100 par value preferred stock outstanding, and 135,000 7.5% semiannual bonds
outstanding, par value $1,000 each. The common stock currently sells for $34 per share and has a
beta of 1.25, the preferred stock currently sells for $91 per share, and the bonds have 15 years to
maturity and sell for 114% of par. The market risk premium is 7.5%, T-bills are yielding 4%, and
Raymond Mining’s tax rate is 35%.
 
a. What is the firm’s market value capital structure? (Enter your answers in whole dollars.)
 
  Market value
Debt 153,900,000
$ 
Equity 289,000,000
$ 
Preferred stock 22,750,000
$ 

 
b. If Raymond Mining is evaluating a new investment project that has the same risk as the firm’s
typical project, what rate should the firm use to discount the project’s cash flows? (Do not round
intermediate calculations. Enter your answer as a percentage rounded to 3 decimal places.)
 
9.872 ± 0.001
Discount rate              %

 
Explanation:
a.
We will begin by finding the market value of each type of financing. We find:
 
MVD = $135,000($1,000)(1.14) = $153,900,000
MVE = $8,500,000($34) = $289,000,000
MVP = $250,000($91) = $22,750,000

 
b.
For projects equally as risky as the firm itself, the WACC should be used as the discount rate.
 
First we can find the cost of equity using the CAPM. The cost of equity is:
 
RE = 0.04 + 1.25 (0.075) = 0.13375 or 13.375%
 
The cost of debt is the YTM of the bonds, so:
P0 = $1,140 = $37.5(PVIFAR%,30) + $1,000(PVIFR%,30)
R = 3.033%
YTM = 3.033% × 2 = 6.065%
 
And the after-tax cost of debt is:
 
RD = (1 – 0.35)(0.06065) = 0.0394252 or 3.94252%
The cost of preferred stock is:
RP = $5 / $91 = 0.0549, or 5.49%
 
And the total market value of the firm is:
 
V = $153,900,000 + $289,000,000 + $22,750,000 = $465,650,000
 
So, the market value weights of the company’s financing is:
 
D/V = $153,900,000 / $465,650,000 = 0.3305
P/V = $22,750,000 / $465,650,000 = 0.0489
E/V = $289,000,000 / $465,650,000 = 0.6206
 
Now we can calculate the WACC as:
WACC = 0.0394252 (0.3305) + 0.13375 (0.6206) + 0.0549 (0.0489) = 0.09872 or 9.872%
References