Question

The Saunders Investment Bank has the following financing outstanding. Debt: 55,000 bonds with a coupon rate of 5.1 percent and a current price quote of 107.1; the bonds have 10 years to maturity and a par value of $1,000. 17,900 zero coupon bonds with a price quote of 29.3, 27 years until maturity, and a par value of $10,000. Both bonds have semiannual compounding. Preferred stock: 150,000 shares of 3.4 percent preferred stock with a current price of $89 and a par value of $100. Common stock: 2,200,000 shares of common stock; the current price is $87 and the beta of the stock is 1.15. Market: The corporate tax rate is 25 percent, the market risk premium is 7.1 percent, and the risk-free rate is 3.5 percent. What is the WACC for the company? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

WACC is calculated by determining the costs of debt, preferred stock, and equity, weighting them by their capital structure proportions, and summing these to arrive at the average cost of capital used for project evaluation and company valuation.

Step-by-step explanation:

The Weighted Average Cost of Capital (WACC) is a key financial metric used to estimate the average cost of a company's sources of capital, which includes both debt and equity. Calculating the WACC involves determining the cost of each type of capital, weighting them by their proportion in the overall capital structure, and then summing these weighted costs. This cost reflects the expected return required by investors and is used for discounting future cash flows for projects and valuations.

To calculate the WACC, the cost of debt (after tax), the cost of preferred stock, and the cost of equity are needed. The cost of debt can be found using the yield to maturity approach on the bonds, considering the given coupon rate, current price, and time to maturity. The cost of preferred stock is calculated by dividing the preferred dividend by the current price of the preferred stock. The cost of equity is determined using the Capital Asset Pricing Model (CAPM), which requires the risk-free rate, market risk premium, and the stock's beta. After calculating these costs, the proportions of debt, preferred stock, and common equity in the capital structure need to be determined, and these costs are then weighted accordingly.

Additional financial concepts, such as the present value of future cash flows, may also be discussed in the context of bond valuation, as shown in the reference information about calculating bond yields, coupon rates, interest rate effects, and present discounted value.

Answer 2

The Weighted Average Cost of Capital (WACC) for Saunders Investment Bank is 9.64%.

Step-by-step explanation:

The WACC (Weighted Average Cost of Capital) for Saunders Investment Bank can be calculated by taking into account the financing outstanding and their respective costs.

Step 1: Calculate the cost of debt:
Debt: 55,000 bonds with a coupon rate of 5.1% and a current price quote of 107.1
The yield to maturity can be calculated using the present value formula:
Yield to Maturity = (Interest payment + (Face value - Current price))/((Face value + Current price)/2)
Interest payment = (Coupon rate * Face value)/2 = (5.1% * 1000)/2 = $25.50
YTM = (25.50 + (1000 - 1071))/(1000 +1071)/2 = 4.80%

Step 2: Calculate the cost of preferred stock:
Preferred stock: 150,000 shares of 3.4% preferred stock with a current price of $89 and a par value of $100
The cost of preferred stock is the dividend rate. So, the cost of preferred stock is 3.4%.

Step 3: Calculate the cost of equity:
Common stock: 2,200,000 shares of common stock, current price of $87, and beta of 1.15
The cost of equity can be calculated using the CAPM (Capital Asset Pricing Model):
Cost of Equity = Risk-free rate + Beta * Market Risk Premium
Risk-free rate = 3.5%, Market Risk Premium = 7.1%
Cost of Equity = 3.5% + 1.15 * 7.1% = 12.165%

Step 4: Calculate the weights of the different sources of financing:
Total Capital = Total Debt + Total Preferred Stock + Total Common Stock
Total Debt = Number of bonds * Face value = 55,000 * 1000 = $55,000,000
Total Preferred Stock = Number of preferred stock shares * Par value = 150,000 * 100 = $15,000,000
Total Common Stock = Number of common stock shares * Current price = 2,200,000 * 87 = $191,400,000
Weights of Debt, Preferred Stock, and Common Stock = Total Debt/Total Capital, Total Preferred Stock/Total Capital, Total Common Stock/Total Capital

Step 5: Calculate the WACC:
WACC = Weight of Debt * Cost of Debt + Weight of Preferred Stock * Cost of Preferred Stock + Weight of Common Stock * Cost of Equity

Using the respective values, the WACC for Saunders Investment Bank is:

WACC = ($55,000,000/$261,400,000) * 4.80% + ($15,000,000/$261,400,000) * 3.4% + ($191,400,000/$261,400,000) * 12.165% = 9.64%