The current cost of Capital of Secure and Safe on a Weighted average basis
Cost of Debt -
The company currently has $50 in bonds which pay a 5.5% coupon
Applicable tax rate – 30%
So cost of the debt is = 0.055(1 - 0.3) = 0.0385 or 3.85%
The cost of this debt is less because of the tax shield. Interest expenses are tax-deductible for the company (Folger, 2018). In other words, the company pays $2,750,000 in coupon payment. The company can save 30% of interest paid in tax payment, or $825,000 is saved in tax, and that reduces the cost of capital for this bond.
Cost of Preferred Cost –
The company has $20 million in preferred stock of par value $50 which pays $2.75 per share
Cost of preferred stock = 2.75 / 50 = 0.055 = 5.5%
Preferred stocks are both equity and debt component. There is no upside for the investor but the dividend payout is consistent. For the company, there is no tax benefit on dividend payout though, on $20 million preferred stocks the company hands out $1,100,000 but there is no tax break for it.
Cost of Common stock –
The company has common cost worth $25 million and cost of capital is 12%
Total market value of working capital = 50 + 20 +25 = $95 million
We add up the bond, preferred stocks and common stocks, and then find out the percentage of each type of funding.
Percentage of bond = 50/95 = 52.63%
Percentage of preferred stocks = 20/95 = 21.05%
Percentage of common stocks = 25/95 = 26.32 %
So, WACC
(0.5263)*(0.0385) + (0.2105)(0.055) + (0.2632) (.12) = 0.02026255+ 0.0115775+ 0.031584 = 0.06342405 = 6.34%
We get the WACC by multiplying the cost of capital and percentage of each capital type and then add all of them.
Cost of capital of the company assuming the $45 million dollar bond issue with a 4.5% coupon is approved
We already have the cost of capitals for previous capital types, we need to find the capital cost for the $45 million, which it wants to issue.
Now if this bond is issued, cost of the bond will be –
0.045(1 – 0.3) = 0.0315 or 3.15% because the interest payment will be tax deductible for the company, that will reduce the effective cost of new capital.
The process to calculate remains same, but the total capital will go up as the $45 million will be added.
With the new $45 bond the total market value of working capital = 50 + 20 +25 +45 = $140 million
Percentage of bond paying 5.5% coupon= 50/140 = 35.71%
Percentage of preferred stocks = 20/140 = 14.29%
Percentage of common stocks = 25/140 = 17.86%
Percent of bond paying 4.5% coupon = 45/140 = 32.14%
With the new $45 bond the WACC will be
(0.3571)(0.0385) + (0.1429)(0.055) + (0.1786) (.12) + (0.3214) (0.0315) = .01374835 + .0078595 + 0.021432 + .0101241 = 0.05316395 or 5.32%
Cost of capital is multiplied with the percentage weight of the capital and then adding all of them.
Reference -
Folger, J ( April 2018). What Is The Formula For Calculating Weighted Average Cost Of Capital (WACC)?. Retrieved from https://www.investopedia.com/ask/answers/063014/what-formula-calculating-weighted-average-cost-capital-wacc.asp
Cost of Debt -
The company currently has $50 in bonds which pay a 5.5% coupon
Applicable tax rate – 30%
So cost of the debt is = 0.055(1 - 0.3) = 0.0385 or 3.85%
The cost of this debt is less because of the tax shield. Interest expenses are tax-deductible for the company (Folger, 2018). In other words, the company pays $2,750,000 in coupon payment. The company can save 30% of interest paid in tax payment, or $825,000 is saved in tax, and that reduces the cost of capital for this bond.
Cost of Preferred Cost –
The company has $20 million in preferred stock of par value $50 which pays $2.75 per share
Cost of preferred stock = 2.75 / 50 = 0.055 = 5.5%
Preferred stocks are both equity and debt component. There is no upside for the investor but the dividend payout is consistent. For the company, there is no tax benefit on dividend payout though, on $20 million preferred stocks the company hands out $1,100,000 but there is no tax break for it.
Cost of Common stock –
The company has common cost worth $25 million and cost of capital is 12%
Total market value of working capital = 50 + 20 +25 = $95 million
We add up the bond, preferred stocks and common stocks, and then find out the percentage of each type of funding.
Percentage of bond = 50/95 = 52.63%
Percentage of preferred stocks = 20/95 = 21.05%
Percentage of common stocks = 25/95 = 26.32 %
So, WACC
(0.5263)*(0.0385) + (0.2105)(0.055) + (0.2632) (.12) = 0.02026255+ 0.0115775+ 0.031584 = 0.06342405 = 6.34%
We get the WACC by multiplying the cost of capital and percentage of each capital type and then add all of them.
Cost of capital of the company assuming the $45 million dollar bond issue with a 4.5% coupon is approved
We already have the cost of capitals for previous capital types, we need to find the capital cost for the $45 million, which it wants to issue.
Now if this bond is issued, cost of the bond will be –
0.045(1 – 0.3) = 0.0315 or 3.15% because the interest payment will be tax deductible for the company, that will reduce the effective cost of new capital.
The process to calculate remains same, but the total capital will go up as the $45 million will be added.
With the new $45 bond the total market value of working capital = 50 + 20 +25 +45 = $140 million
Percentage of bond paying 5.5% coupon= 50/140 = 35.71%
Percentage of preferred stocks = 20/140 = 14.29%
Percentage of common stocks = 25/140 = 17.86%
Percent of bond paying 4.5% coupon = 45/140 = 32.14%
With the new $45 bond the WACC will be
(0.3571)(0.0385) + (0.1429)(0.055) + (0.1786) (.12) + (0.3214) (0.0315) = .01374835 + .0078595 + 0.021432 + .0101241 = 0.05316395 or 5.32%
Cost of capital is multiplied with the percentage weight of the capital and then adding all of them.
Reference -
Folger, J ( April 2018). What Is The Formula For Calculating Weighted Average Cost Of Capital (WACC)?. Retrieved from https://www.investopedia.com/ask/answers/063014/what-formula-calculating-weighted-average-cost-capital-wacc.asp
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