Sound Systems (SS) has 200,000 shares of common stock outstanding at a market price of $37 a share. SS recently paid an annual dividend in the amount of $1.20 per share. The dividend growth rate is 4 percent. SS also has 4,500 bonds outstanding with a face value of $1,000 per bond that are selling at 99 percent of par. The bonds have a 6 percent coupon and a 6.7 percent yield to maturity. If the tax rate is 34 percent, what is the weighted average cost of capital?

the weighted average cost of capital is 6.31 %

Explanation:

Weighted Average Cost of Capital (WACC) is the return required by the providers of long term permanent source of capital to the firm.

WACC = Ke × (E/V) + Kp × (P/V) + Kd × (D/V)

Ke = Cost of equity

    = $1.20 / $37.00 + 0.04

    = 0.0724 or 7.24 %

E/V = Weight of Equity

      = (200,000 × $37) ÷ (200,000 × $37 + 4,500 × $1,000 × 99%)

      = $7,400,000 ÷ ($7,400,000 + $4,455,000)

      = 62.42 %

Kd = Cost of Debt

    = Interest × (1 - tax rate)

    = 6.70 % × (1 - 0.34)

    = 4.42 %

D/V = Weight of Debt

      = (4,500 × $1,000 × 99%) ÷ (200,000 × $37 + 4,500 × $1,000 × 99%)

      = $4,455,000 ÷ ($7,400,000 + $4,455,000)

      = 37.28 %

Therefore,

WACC = 7.24 % × 62.42 % +  4.42 % × 37.28 %

           = 6.31 %

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