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Preston Corp. is estimating its WACC. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sells for $1,100. The firm could sell, at par, $100 preferred stock which pays a 5.52 percent annual dividend, but flotation costs of 5 percent would be incurred. Preston's beta is 1.2, the risk-free rate is 3 percent, and the market risk premium is 5 percent. The firm's marginal tax rate is 40 percent. What is Preston's WACC

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Answer:

Follows are the solution to this question:

Explanation:

[tex]\text{Equity expense = free risk rate+beta} \times \text{market risk premium}[/tex]

                        [tex]=3 \% + 1.2 \times 5 \% \\\\= 0.03 + 1.2 \times 0.05 \\\\= 0.03 +0.06 \\\\= 0.09\\\\=9 \%[/tex]

[tex]\text{Preferred inventory cost} = \frac{\text{annual dividend}}{( price - floation \ rate)}[/tex]

                                     [tex]= \frac{(100 \times 5.46 \%)}{(100-100 \times 5 \%)}\\\\=5.75 \%[/tex]

[tex]\text{Excel feature = RATE(nper, PMT, PV, FV)}[/tex]

                     [tex]=(RATE( \frac{20 \times 2,1000 \times 12 \%}{2,-1100,1000})) \times 2 \\\\=10.77 \%[/tex]

[tex]\text{Debt expense after tax}= 10.77 \% \times (1-40 \%)[/tex]

WACC from Preston   = Capital weight [tex]\times[/tex]  Capital equity costs+cost of common stock [tex]\times[/tex] cost of common shares [tex]\times[/tex] debt cost [tex]\times[/tex] (1-tax rate)

[tex]=60 \% \times 9 \%+20 \% \times 5.75 \%+20 \% \times 6.46 \% \\\\=7.84 \%[/tex]