The capital structure for Magellan Corporation is shown below. Currently, flotation costs are 13% of market value for a new bond issue and $3 per share for preferred stock. The dividends for common stock were $2.50 last year and have an estimated annual growth rate of 6%. Market prices are $1,020 for bonds, $20 for preferred stock, and $30 for common stock. Assume a 34% tax rate. Financing Type % of Future Financing Bonds (8%, $1k par, 16 year maturity) 36% Common equity 45% Preferred stock (5k shares outstanding, $50 par, $1.50 dividend) 19% Total % 100% Compute the company’s WACC. Is this WACC considered reasonable given the assumptions and other relevant information? Explain.
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
The capital structure for Magellan Corporation is shown below. Currently, flotation costs are 13% of market value for a new bond issue and $3 per share for
Financing Type |
% of Future Financing |
Bonds (8%, $1k par, 16 year maturity) |
36% |
Common equity |
45% |
Preferred stock (5k shares outstanding, $50 par, $1.50 dividend) |
19% |
Total % |
100% |
Compute the company’s WACC. Is this WACC considered reasonable given the assumptions and other relevant information? Explain.
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The calculations in step 2 is very hard to read. Can it be written more clearly, please?
![Step 1: Introduction
Company issued capital through different sources like equity, debt, preference and bonds. The objective
of company after raising money is to reduce the cost of raising capital as low as possible. This will
provide information as to how much margin a company is expected to have and distributed.
The net income is divided into two categories: dividend and retained earnings. The dividend is the
income to shareholders that is distributed periodically on the basis of preference and retained earnings
is the saving made by the company for long term investments.
Step 2: WACC
Weighted average cost of capital is the overall capital of each sources of capital raised adjusted with it
capital contribution. The main objective of the company to reduce the overall cost of capital by
providing maximum wealth to the shareholders and ensure higher profitability.
Calculation of WACC:
D1-$2.5(1-6%) $2.65Cost of equity-D1Stock price+g
=$2.6530+6%
=8.8333%6+6
=$1000*8%(1-
96
=14.8333% Cost of bonds-C(1-tax rate)+FV-PNFV+P2*100
34%) +$1000-($1020-$1020*13%) 16$1000+
($1020-$1020*13%)2*100
-$52.8+$7.0375$943.7*100
-6.3407% Cost of preferen
=8.
=$1.50$20-$3*100
ce capital-DividendMarket value*100
8235%
Under this, D1 is the future dividend payment in the next year, g is the growth rate of dividend, FV is the
face value, P is the current market price and C is the coupon payment made annually.
WACC=Cost of equity Weights-Cost of bonds weights-Cost of preference capital weights =14.833
%6*45% +6.3407*36% +8.8235*19% -6.674985%+2.282652% +1.676465% =10.634102% or 10.6
3%
Step 3: WACC reasonable?
The WACC will be taken as lower as possible because the value must be increased, the growth has to be
increased and other than this, company must be profitable. So, for the purpose to check whether the
WACC is reasonable, we need to check it with the rate of return from the invested capital.
The rate of return of the company must be more than the WACC because the cost must be lower than the
overall return. In that case only we could be profitable in long term also.](https://content.bartleby.com/qna-images/question/0facb135-26ca-4e6d-b0e4-e45a10eaf301/e437145d-f6b2-4e54-b662-9fe4be0aa538/h7sjfii_thumbnail.jpeg)
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