Weighted Average Cost of Capital (WACC) Question with Dividend Growth Model

Zee Zee Inc. issued bonds with a face value of $50,000,000. The bonds are currently yielding 4% return with a coupon rate of 5% interest paid quarterly. The # of years till maturity is 10 years.

The corporation just paid a dividend of $3 per share. The dividends are expected to grow at 6% per year indefinitely with the current stock price being at $18 per share. There are 1,500,000 common shares outstanding at this time. Assuming a tax rate of 40%, calculate Zee Zee Inc.'s Weighted Average Cost of Capital (WACC).

Bond Calculations

Equity Calculations

N = 10 x 4 = 40
I/Y = 4% (Rd)
PV = ?
PMT = (-50,000,000 x 0.05) / 4 = $-687,500
FV = -50,000,000
P/Y = 4
C/Y = 4
Solution: PV = $56,156,504 (D)

"Just Paid" = Do = $53
Current Stock Price = Po = $18
Growth = g = 0.06

Po = Do (1+g) / (re - g)
18 = (3)(1.06) / (re - 0.06)
18 = 3.18 / (re - 0.06)
re - 0.06 = 3.18 / 18
re = 0.2367

E = Market Value of Equity
Stock Price x Common Shares O/S
$18 x 1,500,000 = $27,000,000

V = Total Capital Structure
V = 56,156,504 (bonds debt) + 27,000,000 (equity of common shares)
V = 83,156,504

Weighted Average Cost of Capital (WACC) Formula

The formula for WACC is:

[Rd x D/V x (1-5)] + [Re x E/V]

Rd = Bond's yield to Maturity (I/Y in Calculator)
D = Market Value (Present Value) of Bonds
(1 - t) = 1 - tax rate = Interest tax shield deductibility of interest expense
Re = Shareholder's return requirement
V = Total value of all capital (Debt + Equity)

Summary of Important Terms

Rd = 0.04
D = 56,156,504
V = 83,156,504
D/V = 56,156,504 / 83,156,504 = 0.6753
(1 - t) = (1 - 0.4) = 0.6

Re = 0.2367
E = 27,000,000
E/V = 27,000,000 / 83,156,504 = 0.3247

WACC = [Rd x D/V x (1-5)] + [Re x E/V]
WACC = [(0.04)(0.6753)(0.6)] + (0.2367) (0.3247)
WACC = 0.016207 + 0.07686
WACC = 0.093067 -> 9.3067%

Interpretation of WACC

A WACC of 9.3067% means Zee Zee Inc. must earn a return of 9.3067% on all its assets and business operations in order to MAINTAIN the current stock price at $18 per share. If Zee Zee Inc. wants its stock price to go higher, it must achieve a return rate greater than 9.3067%