Solutions to Mini-Case
BioCom, Inc.: Part 3, A Fresh Look at the WACC
This case provides a comprehensive and realistic review of WACC computations and some of the theoretical questions related to the WACC and its uses.
1. Compute the yield to maturity and the after-tax cost of debt for the two bond issues.
Bond 1
$1031 = 35 × (1-(1/(1+YTM/2)12)/r)+1000/(1+YTM/2)12 By trial and error, YTM/2 =3.185%. YTM = Rd = 6.37%
Using a calculator, N=12, PV = -1031, PMT = 35, FV = 1000, solve for i/y = 3.185%
Bond 2
$1035 = 40 × (1-(1/(1+YTM/2)32)/r)+1000/(1+YTM/2)32 By trial and error, YTM/2 =3.81%. YTM = Rd = 7.62%
Using a calculator, N=32, PV = -1035, PMT = 40, FV = 1000, solve for i/y = 3.81%
2. Compute BioCom’s cost of preferred stock.
Rps = $1.50/$19 = 7.89%
3. Compute BioCom’s cost of common equity. Use the average of results from the dividend growth model and the security market line.
Dividend Growth model
Re = $2.50 (1.06)/35 + .06 = 13.57%
CAPM approach:
Re = 3% + 1.2(12%-3%) = 13,8%
Average:
(13.57% + 13.8%)/2 = 13.69%
4. Compute BioCom’s weighted average cost of capital. Should you use book values or market values for this computation?
It is always best to use market weights when computing the Weighted Average Cost of Capital. Also keep in mind that we need to adjust Rd for taxes.
WACC = .15(6.37%)(1-.34) +.20(7.62%)(1-.34) + .10(7.89%) + .55(13.69%) = .631% + 1.006% + .789% + 7.530% = 9.96%
5. BioCom could sell new bonds with maturities of fifteen to twenty years at approximately the same yield as Bond 2. It would, however, incur flotation costs of $20.00 per $1,000 of par value. Estimate the effective interest rate BioCom would have to pay on a new issue of long-term debt.
BioCom would most likely issue bonds with coupon rates to reflect investors current expected yield to maturity, or about 7.62%. This would result in semi-annual coupon payments of $1,000 × .0762/2 = $38.10. BioCom would also realize only
