1. A firm has a capital structure containing 60 percent debt and 40 percent common stock equity. Its outstanding bonds offer investors a 6.5 percent yield to maturity. The risk-free rate currently equals 5 percent, and the expected risk premium on the market portfolio equals 6 percent. The firm's common stock beta is 1.20.
a. What is the firm's required return on equity?
b. Ignoring taxes, use your finding in part (a) to calculate the firm's WACC.
c. Assuming a 40 percent marginal tax rate, recalculate the firm's WACC found in part (b)
d. Compare and contrast the values for the firm's WACC found in parts (b) and (c).
2. A firm has a capital structure containing 40 percent debt, 20 percent preferred stock, and 40 percent common stock equity. The firm's debt has a yield to maturity of 8.1 percent, its preferred stock's annual dividend is $3.10, and the preferred stock's current market price is $50.00 per share. The firm's common stock has a beta of 0.90, and the risk-free rate and the market return are currently 4.0 percent and 13.5 percent, respectively. The firm is subject to a 40 percent marginal tax rate.
a. What is the firm's cost of preferred stock?
b. What is the firm's cost of common stock?
c. Calculate the firm's after-tax WACC.
d. Recalculate the firm's WACC, assuming that its capital structure is deleveraged to contain 20 percent debt, 20 percent preferred stock, and 60 percent common stock.
e. Compare, contrast, and discuss your findings from parts (c) and (d).
(1A) To calculate the return on equity with the information given, it is easiest to use the capital asset pricing model (CAPM).
Return on equity = risk-free rate of return + (beta x market risk premium)
= 0.05 + (1.2 x 0.06) = 0.122 or 12.2%
(1B) WACC is calculated as the sum of each of the components of the firm's capital structure multiplied by their respective weights/fractions. The sum of the weights must equal 1 or 100% as that represents the firm's entire capital structure.
WACC = (return on debt)(% debt in capital structure) + (return on equity)(% equity in capital structure)
= (0.065 x 0.6) + (0.122 x 0.4)
= 0.026 + 0.0488
= 0.0748 or 7.48%
(1C) This questions asks us to recalculate the WACC, but this time we must take into consideration the tax rate. Since interest is tax deductible, we must calculate the after tax cost of debt (because debt has interest - no recalculation for equity because there is no interest or tax benefits involved with the use of equity).
After tax cost of debt = rate of return on debt x (1 - tax rate)
= 0.065 x (1- 0.04)
= 0.039 or 3.9%
We can now use the same formula to calculate ...
Calculations of weighted-average cost of capital (WACC), return on equity (ROE), after-tax cost of debt, market risk premium, and the cost of common stock.