Fairyland Inc. has a $6 million (face value) 30 year bond issue selling for 105.9
percent of par that pays an annual coupon of 8.0%. What would be Fairyland’s
before-tax component cost of debt?
Solving using the Financial Calculator App,
Or, using Excel: =RATE(N,PMT,-PV,FV)
Fairyland Inc. has 4 million shares of common stock outstanding, 1 million shares of
preferred stock outstanding, and 200 thousand bonds. The common shares are selling for $25
per share, the preferred share are selling for $10 per share, and the bonds are selling for 95
percent of their $1,000 par. (See P10-3 for formula to calculate weights).
A. What would be the weight used for equity in the computation of
FarCry’s WACC?
B. What weight should you use for debt in the computation of Fairyland ‘s
WACC?
C. What weight should you use for preferred stock in the computation of
Fairyland ‘s WACC?
WACC Suppose that Ferry Landings, Inc., Inc. has a capital structure of 40%
common equity, 15% preferred stock, and 45% debt. If the before-tax component costs
of common equity, preferred stock and debt are 15%, 10% and 8%, respectively.
What is Ferry Landings, Inc.’s WACC if the firm faces an average tax rate of 30
percent?
Using the WACC equation:
WACC = E/(E+P+D) x RE + P/(E+P+D) x RP + D/(E+P+D) x
RD
Where; E = Market value of common equity
P = Market value of preferred stock
D = Market value of Debt
RE = cost of common equity
RP = cost of preferred stock
RD = cost of Debt
An all-equity firm is considering the projects shown below. The T-bill rate is
4% and the expected market return is 14%. Using the CAPM, calculate the risk
adjusted required return for each project. If the firm uses its current WACC
of 12 percent to evaluate these projects, which project(s), if any, will be
incorrectly rejected? Which project(s), if any, will be incorrectly accepted?
Project Expected Return Project Beta
A 10.0% 0.5
B 19.0% 1.2
C 13.0% 1.4
D 20.0% 2.5
CAPM: E(Ri) = RF + [Bi X (E(Rm) – Rf)]
Where; E(Ri) = expected return for project i.
RF = risk-free rate (T-bill rate)
Bi = Beta for project i.
E(Rm) = expected return for the market.
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