Question

1. In the previous problem, suppose the most recent dividend was $4 and the dividend growth rate is 6 percent. Assume that the overall cost of debt is the weighted average of that implied by the two outstanding debt issues. Both bonds make semiannual payments. The tax rate is 35 percent. What is the company’s WACC?

Please show work and calculations, thank you!

(THIS IS THE PREVIOUS PROBLEM-BELOW)

1. Filer Manufacturing has 8.2 million shares of common stock outstanding. The current share price is $52, and the book value per share is $5. Filer Manufacturing also has two bond issues outstanding. The first bond issue has a face value of $70 million, an 8 percent coupon, and sells for 104 percent of par. The second issue has a face value $50 million, a 7.5 percent coupon, and sells for 97 percent of par. The first issue matures in 10 years, the second in 6 years.(assume each unit of bond has a face value of $1,000)

1. What are Filer’s capital structure weights on book value basis?

   Book value of equity = 8.2m * $5

   Book value of equity = $41m

   Book value of debt = $70m + $50m = $120m

   Total capital = $41m+$120m = $161m

   Equity weight = $41m/$161m = 25.5% Debt weight = $120m/$161m = 74.5%

2. What are Filer’s capital structure weights on a market value basis?

   Market value of equity = 8.2m * $52

   = $426.4m

   Market value of debt = $70m*1.04 + $50m*0.97

   = $121.3m

   Total capital = $426.4m+$121.3m = $547.7m

   Equity weight = $426.4m/$547.7m = 77.85%

   Debt weight = $121.3m/$547.7m = 22.15%

3. Which are more relevant, the book or market value weights? Why? Market weights are more relevant because the market value portrays the correct value of the balance sheet After calculation the weights, we can tell there is an inconsistency between the weights.

Answer 1

From Gordon's constant growth model

Cost of equity = last dividend*(1+constant growth rate)/current share price + constant growth rate

=$4*1.06/$52+0.06

=0.14154 or 14.154%

Cost of bond issue is the same as the YTM of the bond

Market value = 104% * $70 million = $72.8 million

Semiannual coupon = $70 million *8%/2 =$2.8 million

No of payments = 10*2 =20

So, semiannual YTM (r) is given by

2.8/r*(1-1/(1+r)^20) + 70/(1+r)^20 = 72.8

Solving for r using Excel , r = 0.03713102

So Annual YTM =2*r = 0.074262 or 7.4262% which is the pretax cost of debt of the 1st bond issue

For 2nd bond issue

Market value = 97% * $50 million = $48.5 million

Semiannual coupon = $50 million *7.5%/2 =$1.875 million

No of payments = 6*2 =127.4262

So, semiannual YTM (r) is given by

1.875/r*(1-1/(1+r)^12) + 50/(1+r)^12 = 48.5

Solving for r using Excel , r = 0.0407097

So Annual YTM =2*r = 0.081419 or 8.142% which is the pretax cost of debt of the 2nd bond issue

So, Weighted average cost of debt (pretax)

= 72.8/(72.8+48.5)*7.4262%+48.5/(72.8+48.5)*8.142%

=0.07712402 or 7.71%

WACC = 0.7785*14.154%+0.2215*7.71%*(1-0.35)

= 0.12128936 or 12.13%

So, WACC is 12.13%