The market value of Fortescue's ordinary shares, preference shares and debt are $8 billion, $4 billion and $12 billion, respectively. Fortescue has a beta of 1.3, the market risk premium is 7% and the risk-free rate of interest is 4%. Fortescue's preference shares pay a dividend of $4 each year and trades at a price of $30 per share. Fortescue's debt trades with a yield to maturity of 8.5%. What is Fortescue's weighted average cost of capital if its tax rate is 30%?

Question

Quizplus · Accepted Answer

To calculate the weighted average cost of capital (WACC), we need to find the cost of each type of financing and then weight them according to their proportion in the capital structure.

Cost of equity:
Using the Capital Asset Pricing Model (CAPM), we can calculate the cost of equity as follows:

Cost of equity = Risk-free rate + Beta x Market risk premium 
= 4% + 1.3 x 7% 
= 12.1%

Weighting factor = Market value of equity / Total market value 
= $8 billion / ($8 billion + $4 billion + $12 billion) 
= 0.32

Cost of preference shares:
The cost of preference shares is the dividend yield, which is the dividend per share divided by the price per share:

Cost of preference shares = Dividend / Price 
= $4 / $30 
= 13.3%

Weighting factor = Market value of preference shares / Total market value 
= $4 billion / ($8 billion + $4 billion + $12 billion) 
= 0.16

Cost of debt:
The cost of debt is the yield to maturity (YTM), which is the effective interest rate that the company pays on its debt:

Cost of debt = YTM x (1 - Tax rate) 
= 8.5% x (1 - 30%) 
= 5.95%

Weighting factor = Market value of debt / Total market value 
= $12 billion / ($8 billion + $4 billion + $12 billion) 
= 0.48

WACC:
Finally, we can calculate the weighted average cost of capital as follows:

WACC = (Cost of equity x Weighting factor) + (Cost of preference shares x Weighting factor) + (Cost of debt x Weighting factor) 
= (12.1% x 0.32) + (13.3% x 0.16) + (5.95% x 0.48) 
= 9.56%

Therefore, the correct answer is B) 9.56%.

The Market Value of Fortescue's Ordinary Shares, Preference Shares and Debt