Sound Systems has 200 shares of common stock outstanding at a market price of $37 a share.The firm recently paid an annual dividend in the amount of $1.20 per share and has a dividend growth rate of 4 percent.The firm also has 5 bonds outstanding with a face value of $1,000 per bond that are selling at 99 percent of par.The bonds have a coupon rate of 6 percent and a yield to maturity of 6.7 percent.All interest is tax deductible.If the tax rate is 21 percent,what is the weighted average cost of capital?

Question

Quizplus · Accepted Answer

The weighted average cost of capital (WACC) is calculated using the cost of equity and the after-tax cost of debt. The cost of equity can be estimated using the Gordon Growth Model: Cost of Equity = (Dividend per share / Current stock price) + Growth rate = ($1.20 / $37) + 0.04 = 0.0724 or 7.24%. The cost of debt is the yield to maturity adjusted for taxes: After-tax cost of debt = Yield to maturity * (1 - Tax rate) = 0.067 * (1 - 0.21) = 0.0529 or 5.29%. The market value of equity is 200 shares * $37 = $7,400. The market value of debt is 5 bonds * $1,000 * 0.99 = $4,950. The WACC is calculated as: WACC = (Equity / Total value) * Cost of equity + (Debt / Total value) * After-tax cost of debt = ($7,400 / $12,350) * 0.0724 + ($4,950 / $12,350) * 0.0529 = 0.0654 or 6.54%.

Sound Systems Has 200 Shares of Common Stock Outstanding at a Market