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Your next assignment as a financial management intern is to apply the knowledge that you acquired while engaging in the cost of capital discussion that you had with your colleagues. In this task, you will be calculating the weighted cost of capital for a firm using the book value of the components and the concepts presented in this phase.

Using the most current annual financial statements from the company you analyzed in Phase 1, determine the percentage of the firm’s assets that are currently be financed with debt (total liabilities), preferred stock, and common stock (common equity). It is very possible that your firm will have very little or no preferred stock, so in this class, the percent would be “zero.” Your ratios should add up to 100%. You will also need to calculate the firm’s average tax rate using the income tax expense divided by the firm’s income before taxes. Use the following tables:

Company

Total Assets

Total Liabilities

Total Preferred Stock

Total Common Equity

Dollar Value

       

% of Assets

       

 

Company

Income before Tax

Income Tax Expense

Average Tax Rate (%)

       

 

The first component to determine is the cost of debt. You mentor suggests using the Web site that you used in the previous Phase to find the pretax yield-to-maturity of a bond with at least 5 years left before maturity. Using the following table, calculate the firm’s after-tax cost of debt:

Yield to Maturity

1 – Average Tax Rate

After-tax Cost of Debt

     

 

Now you will need to calculate the cost of preferred stock. You can use the following table:

Annual Dividend

Current Value of Preferred Stock

Cost of Preferred Stock (%)

     

 

To calculate the cost of common equity, you can use the CAPM model. Using current stock data, the yield on the 5-year treasury bond, and the return on the market calculated in Phase 2, you can calculate the cost of common equity using the following table:

5-year Treasury Bond Yield
(risk-free rate)

Stock’s Beta

Return on the Top 500 Stocks (market return)

Cost of Common Equity

       

 

Now, you can use the cost and ratios from above to calculate the firm’s weighted average cost of capital (WACC) using the following table:

 

After-Tax Cost of Debt

Cost of Preferred Stock

Cost of Common Equity

WACC

Unweighted Cost

       

Weight of Component

       

Weighted Cost of Component

       

 

  • After completing the required calculations, explain your results in a Word document, and attach the spreadsheet showing your work. Be sure to explain the following:
    • How would you expect the weighted average cost of capital (WACC) to differ if you had used market values of equity rather than the book value of equity, and why?
    • What would you expect would happen to the cost of equity if you had to raise it by selling new equity, and why?
    • If the after-tax cost of debt is always less expensive than equity, why don’t firms use more debt and less equity?
    • What are some of the advantages and disadvantages of raising capital by using debt?
    • How would “floatation costs” impacted the WACC, and how could they have been incorporated in the formula?

Note: You can find information about the top 500 stocks at this Web site.

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