Assume that you are the assistant to the CFO of XYZ Company. Your task is to estimate XYZ's WACC using the following data:
- The firm's tax rate is 40%.
- The current price of the 12% coupon, semiannual payment, non-callable bonds with 15 years to maturity is $1,153.72. New bonds could be issued with no flotation costs.
- The current price of the firm's 10% $100 par value, quarterly dividend, perpetual preferred stock is $116.95. The flotation costs on a new issue would be 5% of the proceeds.
- The current price of the common stock is $50 per share. The last dividend was $4.19, and dividends are expected to grow at a constant rate of 5%. The firm's beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is 6%.
- he target capital structure is 30% long-term debt, 10% preferred stock, and 60% common equity.
Procedure
- What sources of capital should be included when you estimate XYZ's WACC?
- Should the component costs be estimated on a before or after-tax basis? Why?
- Should the component costs be historical or marginal costs? Why?
- What is the market interest rate on XYZ's debt and its component cost of debt?
- What is the firm's cost of preferred stock?
- Why is the firm's cost of preferred stock lower than the yield to maturity on its debt (Hint: Think about taxes.)
- What are the two primary ways that firms raise common equity?
- XYZ does not plan to sell common stock. Using the CAPM approach, what is the firm's cost of common equity?