As a newly hired financial analyst, your first job at VersaLife Corporation is to calculate the company's cost of capital. The present capital structure, which is considered optimal, is as follows: $$\begin{array} { | c | c | }
\hline & \text { Market Value } \
\hline \text { Debt } & \$ 80 \text { million } \
\hline \text { Preferred Stock } & \$ 10 \text { million } \
\hline \begin{array} { c }
\text { Common } \
\text { Equity }
\end{array} & \$ 110 \text { million } \
\hline \text { Total Capital } & \$ 200 \text { million } \
\hline
\end{array}$$ If VersaLife Corporation issues new debt, then the bond market expects a yield of 7.5%. Preferred stock is trading for $96, has a $100 par value and pays an annual dividend of 8% (the next dividend is due in one year). Common equity has a beta of 1.20, the market risk premium is 5%, and the risk-free rate is 3%. If the firm's tax rate is 40%, what is the weighted average cost of capital? Round answers to the nearest tenth.

Question

As a newly hired financial analyst, your first job at VersaLife Corporation is to calculate the company's cost of capital. The present capital structure, which is considered optimal, is as follows: $$\begin{array} { | c | c | } 
\hline & \text { Market Value } \
\hline \text { Debt } & \$ 80 \text { million } \
\hline \text { Preferred Stock } & \$ 10 \text { million } \
\hline \begin{array} { c } 
\text { Common } \
\text { Equity }
\end{array} & \$ 110 \text { million } \
\hline \text { Total Capital } & \$ 200 \text { million } \
\hline
\end{array}$$ If VersaLife Corporation issues new debt, then the bond market expects a yield of 7.5%. Preferred stock is trading for $96, has a $100 par value and pays an annual dividend of 8% (the next dividend is due in one year). Common equity has a beta of 1.20, the market risk premium is 5%, and the risk-free rate is 3%. If the firm's tax rate is 40%, what is the weighted average cost of capital? Round answers to the nearest tenth.

Quizplus · Accepted Answer

The correct answer is A. The weighted average cost of capital (WACC) is calculated as follows:WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc) + (P/V) * Rpwhere:E = market value of common equityV = total capitalRe = cost of common equityD = market value of debtRd = cost of debtTc = tax rateP = market value of preferred stockRp = cost of preferred stockIn this case, we have:E = $110 millionV = $200 millionRe = 3% + 1.20 * 5% = 9%D = $80 millionRd = 7.5%Tc = 40%P = $10 millionRp = 8%Plugging these values into the formula, we get:WACC = (110/200) * 9% + (80/200) * 7.5% * (1 - 0.40) + (10/200) * 8%WACC = 0.55 * 9% + 0.40 * 7.5% * 0.60 + 0.05 * 8%WACC = 4.95% + 1.80% + 0.40%WACC = 7.2%Therefore, the weighted average cost of capital is 7.2%.

As a Newly Hired Financial Analyst, Your First Job at VersaLife