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Dear Sir, can you help to explain why calculating the WACC, kd in the answer don’t multiple with 1-tax?
Thank you very much
———-N Co has just paid a dividend of 66 cents per share and has a cost of equity of 12%. The dividends of the company have grown in recent years by an average rate of 3% per year. The ordinary shares of the company have a par value of 50 cents per share and an ex div market value of $8•30 per share.
The long-term borrowings of NN Co consist of 7% bonds that are redeemable in six years’ time at their par value of $100 per bond. The current ex interest market price of the bonds is $103•50.
The preference shares of NN Co have a nominal value of 50 cents per share and pay an annual dividend of 8%. The ex div market value of the preference shares is 67 cents per share.
NN Co pay profit tax at an annual rate of 25% per year
Answer
Annual preference dividend = 8% x 50 cents = 4 cents per share
Cost of preference shares = 100 x (4/67) = 6%
Number of ordinary shares = 50/0·5 = 100m shares
Market value of equity = Ve = 100m shares x 8·30 = $830m
Number of preference shares = 25/0·5 = 50m shares
Market value of preference shares = Vp = 0·67 x 50m = $33·5m
Market value of long-term borrowings = Vd = 20 x 103·50/100 = $20·7m
Total market value of company = (Ve + Vd + Vp) = (830 + 33·5 + 20·7) = $884·2m
WACC = (keVe + kpVp + kd(1 – T)Vd)/ (Ve + Vp + Vd) = (12 x 830 + 6 x 33·5 + 4·6 x 20·7)/884·2 = 11·6%It is redeemable debt, and so the cost of debt of 4.6% is the IRR of the after-tax flows to the company. It is already after tax and so we do not multiply by (1-T).
I do suggest you watch my free lectures on the calculations of cost of capital where this is explained. (The lectures are a complete free course for Paper FM and cover everything needed to pass the exam well.)
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