Weighted Average Cost of Capital for Clay Industries

Calculation of Component Cost of Common Equity

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The management of Clay Industries have adhered to the following capital structure: 50% debt, 45% common equity, and 5% perpetual preferred equity. The following information applies to the firm: Before-tax cost of debt = 7.5% Combined state/federal tax rate = 35% Expected return on the market = 14.5% Annual risk-free rate of return = 5.25% Historical Beta coefficient of Clay Industries Common Stock = 1.15 Annual preferred dividend = $1.35 Preferred stock net offering price = $17.70 Expected annual common dividend = $0.45 Common stock price = $30.90 Expected growth rate = 11.75% Subjective risk premium = 3.8% Given this information, and using the Capital Asset Pricing Model to calculate the component cost of common equity, what is the Weighted Average Cost of Capital for

Clay Industries?

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A. B. C. D. E. F.

D

The calculation of the Weighted Average Cost of Capital is as follows: {fraction of debt * [yield to maturity on outstanding long-term debt][1-combined state/federal income tax rate]} + {fraction of preferred stock * [annual dividend/net offering price]} + {fraction of common stock * cost of equity}. The cost of common equity can be calculated using three methods, the Capital Asset Pricing Model (CAPM), the Dividend-Yield-plus-Growth-Rate (or Discounted Cash Flow) approach, and the

Bond- Yield-plus-Risk-Premium approach. In this example, you are asked to calculate the cost of common equity using the Capital Asset Pricing Model (CAPM).

This approach involves the following equation: {risk-free rate +beta[expected return on the market - risk-free rate]}. Specifically, the calculation of the component cost of common equity using the CAPM is as follows: {[5.25% + 1.15(14.5%-5.25%]} = 15.888%. The after-tax cost of debt can be found by multiplying the yield to maturity on the firm's outstanding long-term debt (7.5%) by (1-tax rate). Using this method, the after-tax cost of debt is found as 4.875%. The calculation of the cost of perpetual preferred stock is relatively straightforward, simply divide the annual preferred dividend by the net offering price. Using this method, the cost of preferred stock is found as 7.627%. Incorporating these figures into the WACC equation gives the answer of 9.968%.

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