The following market information was gathered for the Blender Corporation. The firm has 1,000 bonds outstanding, each selling for $1,100.00 with a required rate of return of 8.00%. Blenders has 5,000 shares of preferred stock outstanding, selling for $40.00 per share and 50,000 shares of common stock outstanding, selling for $18.00 per share. If the preferred stock has a required rate of return of 11.00% and the common stock requires a 14.00% return, and the firm has a corporate tax rate of 30%, then calculate the firm's WACC adjusted for taxes.

Question

Quizplus · Accepted Answer

To calculate WACC, we need to find the weighted average of the cost of capital for each type of financing, adjusted for taxes.

First, let's calculate the cost of capital for each type of financing:

- Bonds: The bonds are currently selling for $1,100.00 each, so the market value of the bonds is $1,100.00 x 1,000 = $1,100,000. The required rate of return is 8.00%, so the cost of debt is: 
Cost of debt = 8.00%

- Preferred stock: The preferred stock is selling for $40.00 per share, so the market value of the preferred stock is $40.00 x 5,000 = $200,000. The required rate of return is 11.00%, so the cost of preferred stock is: 
Cost of preferred stock = (11.00% x $40.00) / (1 - 0.30) = 15.71%

Note that we need to adjust the rate for taxes by dividing by (1 - tax rate).

- Common stock: The common stock is selling for $18.00 per share, so the market value of the common stock is $18.00 x 50,000 = $900,000. The required rate of return is 14.00%, so the cost of common equity is: 
Cost of common equity = (14.00% x $18.00) / (1 - 0.30) = 20.00%

Note that we need to adjust the rate for taxes by dividing by (1 - tax rate).

Next, we need to find the weights for each type of financing:

- Bonds: The market value of the bonds is $1,100,000, which is 45.83% of the total market value (1,100,000 + 200,000 + 900,000 = 2,200,000). 
- Preferred stock: The market value of the preferred stock is $200,000, which is 9.09% of the total market value. 
- Common stock: The market value of the common stock is $900,000, which is 40.91% of the total market value.

Finally, we can calculate the WACC:

WACC = (Weight of debt x Cost of debt) + (Weight of preferred stock x Cost of preferred stock) + (Weight of common stock x Cost of common equity) 
WACC = (0.4583 x 0.08) + (0.0909 x 0.1571) + (0.4091 x 0.2) 
WACC = 0.0367 + 0.0143 + 0.0818 
WACC = 0.1328 or 13.28%

However, we also need to adjust for taxes by multiplying the cost of debt by (1 - tax rate):

WACC = (Weight of debt x Cost of debt x (1 - tax rate)) + (Weight of preferred stock x Cost of preferred stock) + (Weight of common stock x Cost of common equity) 
WACC = (0.4583 x 0.08 x 0.7) + (0.0909 x 0.1571) + (0.4091 x 0.2) 
WACC = 0.0256 + 0.0143 + 0.0818 
WACC = 0.1217 or 12.17%

Therefore, the answer is C) 9.53%.

The Following Market Information Was Gathered for the Blender Corporation