Estimating Weighted Average Cost of Capital

Assume that you are the assistant to the CFO of XYZ Company.  Your task is to estimate XYZ’s WACC using the following data:

1. The firm’s tax rate is 40%.
2. The current price of the 12% coupon, semiannual payment, non-callable bonds with 15 years to maturity is $1,153.72.  New bonds could be issued with no flotation costs.
3. The current price of the firm’s 10% $100 par value, quarterly dividend, perpetual preferred stock is $116.95.  The flotation costs on a new issue would be 5% of the proceeds.
4. The current price of the common stock is $50 per share.  The last dividend was $4.19, and dividends are expected to grow at a constant rate of 5%.  The firm’s beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is 6%.
5. The target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.

Procedure

1. What sources of capital should be included when you estimate XYZ’s WACC?
2. Should the component costs be estimated on a before or after-tax basis? Why?
3. Should the component costs be historical or marginal costs? Why?
4. What is the market interest rate on XYZ’s debt and its component cost of debt?
5. What is the firm’s cost of preferred stock?
6. Why is the firm’s cost of preferred stock lower than the yield to maturity on its debt (Hint: Think about taxes.)
7. What are the two primary ways that firms raise common equity?
8. XYZ does not plan to sell common stock.  Using the CAPM approach, what is the firm’s cost of common equity?
9. What is the firm’s WACC?

Answer Preview-Estimating Weighted Average Cost of Capital