WACC Practice

Use the following information to estimate this firm’s WACC. Doing the work in Excel, should produce a figure of 7.90%.

The firm has no preferred stock. Its common stock dividend per share has grown from $1.55 five years ago to $2.00 today. This rate of growth is expected to continue into the foreseeable future. The firm’s stock has a beta of 1.80, the risk-free rate is 3%, and the expected return on the market is 7%. Each share of common stock is selling for $45. Analysts believe that a 4% premium over the firm’s bond yield is justified for the required return on the firm’s common equity.

The firm’s 6% coupon, 15-year bonds pay interest twice a year, and are selling for $973. The book value of the firm’s debt is $75m, and the book value of the firm’s common stock & paid-in surplus is $55m. The firm has 3m shares outstanding, and faces a marginal tax rate of 40%.
WACC Estimation
Travel Corp was formed by merging several regional motel chains. The firm’s balance sheet is as follows:

December 31, 200X
($m)

Cash 10 Accounts Payable 10
Accounts Receivable 20 Accruals 10
Inventories 20 Short Term Debt 5

Current Assets 50 Current Liabilities 25

Net Fixed Assets 50 Long Term Debt 30
Preferred Stock 5
Common Equity
Common Stock 10
Retained Earnings 30
Common Equity 40

Total Assets 100 Total Liab. & Equity 100

Note:
• Short-term debt consists of bank loans at a cost of 10%. These loans are used to finance receivables and inventories purely on a seasonal basis.
• Long-term debt consists of 20-year semiannual mortgage bonds with a coupon of 6%. Today, these yield 9%.
• The firm’s perpetual preferred stock pays quarterly dividends of $2 per share, has a par value of $100 per share, and is yielding 11%. New issues will involve a flotation cost of 5%.
• The company has 4 million shares of common stock outstanding with a current price of $20. The firm has just paid out a dividend of $1 per share. Earnings per share (EPS) were $2 for the year just ended. The firm’s average return on equity (ROE) is 24%, and analysts expect this to hold for the future.
• Analysts’ estimates of the firm’s beta range between 1.3 and 1.7. The T-bond rate is 6.25%, and brokerage houses estimate the market risk premium in the range of 4.5% to 5.5%.
• A recent poll by the company of a group of pension fund investment managers revealed that the fund managers would attach a premium of between 4 and 6% over the company’s bond yield to compensate for the risk of investing in the firm’s equity.
• The firm faces a tax rate of 40% (federal plus state).

You are a financial analyst reporting to the firm’s Treasurer, who has asked you to estimate the firm’s WACC using the available information.