# Growth company's current share price is $20 and is expected to pay a $1 dividend per share next...

## Question:

Growth company's current share price is $20 and is expected to pay a $1 dividend per share next year. After that, the firm's dividends are expected to grow at a rate of 4% per year. Growth company has existing debt issued three years ago with a coupon rate of 6%. The firm just issued new debt at a par with a coupon rate of 6.5%.

a. What is Growth Company's pre-tax cost of debt?

b. Growth Company also has preferred stock outstanding that pays $2 per share fixed dividend. If the stock is currently price at $28, what is Growth Company's cost of preferred stock?

c. What is an estimate of Growth Company?s cost of equity?

d. Growth Company has 5 million common shares outstanding and 1 million preferred shares outstanding, at its total book value is $50 million. Its liabilitiies have a market value of $20 million. If Growth Company's common and preferred shares priced as in parts a and b, what is the market value of Growth Company's assets?

e. Growth Company faces a 35% tax rate. Given the information in parts a through d, and your answers to those problems, what is Growth Company's WACC?

## WACC and its Components:

This question is about calculating different components of WACC, the weighted average cost of capital and then calculating the WACC. So, for this , the cost of equity, cost of debt and cost of preferred equity if any has to be derived.

## Answer and Explanation:

**a.** The pre-tax cost of debt is the firm?s YTM on current debt. Since the company has recently issued its debt at par, its coupon rate must equal its YTM. Therefore YTM and the pre-tax cost of debt is 6.5%

**b.** The cost of preferred stock is the Preference dividend divided by stock price. Therefore,

Kp = $2/$28 = 7.14%

**c.** Ke = D1/P0 + g

= $1/$20 + 0.04

= .09 or 9%

**d.** Market value of debt = $20 million

Market value of preferred stock = $28 per share x 1 million preferred shares =$28 million

Market value of equity = $20 per share x 5 million shares outstanding = $100million

Market value of assets = $20 + 28 + 100 = $148 million

**e.** WACC = E/V x Ke + D/V x Kd(1-t) + P/V x Kp

= 100/148 x 0.09 + 20/148 x .065(1-.35) + 28/148 x 0.0714

= .0608 + 0.0057 + .0135

= 0.08 or 8%

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from Financial Accounting: Help and Review

Chapter 8 / Lesson 7