Phillips Equipment has 6,500 bonds outstanding that are selling at 96.5 percent of par. Bonds with similar characteristics are yielding 6.7 percent, pretax. The company also has 48,000 shares of 5.5 percent preferred stock and 75,000 shares of common stock outstanding. The preferred stock sells for $64 a share. The common stock has a beta of 1.32 and sells for $41 a share. The preferred stock has a stated value of $100. The U.S. Treasury bill is yielding 2.2 percent and the return on the market is 10.6 percent. The corporate tax rate is 21 percent. What is the weighted average cost of capital?

Question

Quizplus · Accepted Answer

To calculate the weighted average cost of capital (WACC), we need to find the costs of debt, preferred stock, and equity, and then weight them according to the market values of debt, preferred stock, and equity.1. Cost of Debt (Rd):Given that the bonds are selling at 96.5% of par, and they have a yield of 6.7%, we can use the yield as the cost of debt before taxes. The after-tax cost of debt is then calculated as Rd(1-Tc), where Tc is the corporate tax rate.Rd = 6.7% * (1 - 0.21) = 6.7% * 0.79 = 5.293%2. Cost of Preferred Stock (Rp):The cost of preferred stock is the dividend divided by the current price. The dividend is 5.5% of the $100 par value, so $5.50 per share. The price is $64.Rp = $5.50 / $64 = 8.59%3. Cost of Equity (Re) using CAPM:Re = Rf + Beta * (Rm - Rf), where Rf is the risk-free rate, Beta is the beta of the stock, and Rm is the return on the market.Re = 2.2% + 1.32 * (10.6% - 2.2%) = 2.2% + 1.32 * 8.4% = 2.2% + 11.088% = 13.288%4. Market Values:- Debt: 6,500 bonds * $1,000 * 96.5% = $6,272,500- Preferred Stock: 48,000 shares * $64 = $3,072,000- Common Equity: 75,000 shares * $41 = $3,075,000Total Market Value = $6,272,500 + $3,072,000 + $3,075,000 = $12,419,5005. Weights:- Wd = $6,272,500 / $12,419,500 = 0.505- Wp = $3,072,000 / $12,419,500 = 0.247- We = $3,075,000 / $12,419,500 = 0.2486. WACC:WACC = (Wd * Rd) + (Wp * Rp) + (We * Re) = (0.505 * 5.293%) + (0.247 * 8.59%) + (0.248 * 13.288%) = 2.67% + 2.12% + 3.29% = 8.09%Therefore, the correct answer is A) 8.09 percent.

Phillips Equipment Has 6,500 Bonds Outstanding That Are Selling at 96.5