Comprehensive Problem

1. A corporation has 10,000 bonds outstanding with a 6% annual coupon rate, 8 years to
maturity, a $1,000 face value, and a $1,100 market price. The cost of debt is 4.48%. The
company’s 100,000 shares of preferred stock pay a $1.50 annual dividend, and sell for
$30 per share. The company’s 500,000 shares of common stock sell for $25 per share
and have a beta of 1.5. The risk free rate is 4%, and the market return is 12%. Assuming
a 40% tax rate, what is the company’s WACC?
𝑀𝑉 𝑜𝑓 𝑑𝑒𝑏𝑡 = 10.000 ∗ 1100 = $11.000.000
𝑀𝑉 𝑜𝑓 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 = 100.000 ∗ 30 = $3.000.000
𝑀𝑉 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 = 500.000 ∗ 25 = $12.500.000
𝑇𝑜𝑡𝑎𝑙 𝑀𝑉 = $11.000.000 + $3.000.000 + $12.500.000 = $26.500.000

11.000.000
𝑊𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 = = 0,415
26.500.000
3.000.000
𝑊𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 = = 0,113
26.500.000
12.500.000
𝑊𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 = = 0,472
26.500.000

1,5
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 = = 0,05
30
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 = 0,04 + 1.5 ∗ (0,12 − 0,04) = 0,16

𝑊𝐴𝐶𝐶 = 0,415 ∗ 0,048 ∗ (1 − 0.4) + 0,113 ∗ 0,05 + 0,472 ∗ 0,16 = 0,093 = 9.3%
2. Millie Co. has a target capital structure of 60% common stock, and 40% debt. The cost
of equity is 12%, the cost of preferred stock is 5% and the pretax cost of debt is 7%. The
tax rate is 35%.

a. What is Millie Co.’s WACC?

WC = 0,6
WD = 0,4
Wps = 0
RC = 12%
Rps = 5%
RD = 7%
Tax = 35%

𝑊𝐴𝐶𝐶 = 𝑊C 𝑅C + 𝑊D 𝑅D ∗ (1 − 𝑇) + 𝑊ps 𝑅ps

𝑊𝐴𝐶𝐶 = 0,6 ∗ 0,12 + 0,4 ∗ 0,07 ∗ (1 − 0,35) + 0 ∗ 0,05
𝑊𝐴𝐶𝐶 = 0,072 + 0,028 ∗ 0,65 + 0
𝑊𝐴𝐶𝐶 = 0,09

b. The company president has asked you why the company doesn’t use more preferred
stock financing because it costs less than debt. What would you tell the president?

Since interest is tax deductible and dividends are not, we must look at the after-tax
cost of debt. Hence, on an after-tax basis, debt is cheaper than the preferred stock.