Average Tax Rate

Your next assignment as a financial management intern is to apply the knowledge that you acquired while engaging in the cost of capital discussion that you had with your colleagues. In this task, you will be calculating the weighted cost of capital for a firm using the book value of the components and the concepts presented in this phase.

Using the most current annual financial statements from the company you analyzed in Phase 1, determine the percentage of the firm's assets that are currently be financed with debt (total liabilities), preferred stock, and common stock (common equity). It is very possible that your firm will have very little or no preferred stock, so in this class, the percent would be "zero." Your ratios should add up to 100%. You will also need to calculate the firm’s average tax rate using the income tax expense divided by the firm's income before taxes. Use the following tables:

 

Company
   

Total Assets
   

Total Liabilities
   

Total Preferred Stock
   

Total Common Equity

Dollar Value
                    

% of Assets
                    

 

 

Company
   

Income before Tax
   

Income Tax Expense
   

Average Tax Rate (%)
                

 

The first component to determine is the cost of debt. You mentor suggests using the Web site that you used in the previous Phase to find the pretax yield-to-maturity of a bond with at least 5 years left before maturity. Using the following table, calculate the firm's after-tax cost of debt:

 

Yield to Maturity
   

1 - Average Tax Rate
   

After-tax Cost of Debt
           

 

Now you will need to calculate the cost of preferred stock. You can use the following table:

 

Annual Dividend
   

Current Value of Preferred Stock
   

Cost of Preferred Stock (%)
           

 

To calculate the cost of common equity, you can use the CAPM model. Using current stock data, the yield on the 5-year treasury bond, and the return on the market calculated in Phase 2, you can calculate the cost of common equity using the following table:

 

5-year Treasury Bond Yield

(risk-free rate)
   

Stock's Beta
   

Return on the Top 500 Stocks (market return)
   

Cost of Common Equity
                

 

Now, you can use the cost and ratios from above to calculate the firm's weighted average cost of capital (WACC) using the following table:

 
    

After-Tax Cost of Debt
   

Cost of Preferred Stock
   

Cost of Common Equity
   

WACC

Unweighted Cost
                    

Weight of Component
                    

Weighted Cost of Component
                    

 

    After completing the required calculations, explain your results in a Word document, and attach the spreadsheet showing your work. Be sure to explain the following:
        How would you expect the weighted average cost of capital (WACC) to differ if you had used market values of equity rather than the book value of equity, and why?
        What would you expect would happen to the cost of equity if you had to raise it by selling new equity, and why?
        If the after-tax cost of debt is always less expensive than equity, why don't firms use more debt and less equity?
        What are some of the advantages and disadvantages of raising capital by using debt?
        How would "floatation costs" impacted the WACC, and how could they have been incorporated in the formula?

Note: You can find information about the top 500 stocks at this Web site.

Reference

S&P 500 index chart. (2014). Retrieved from the Yahoo! Finance Web site: http://finance.yahoo.com/echarts?s=%5egspc+interactive#symbol=^gspc;range=1y;compare=;indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=;