Question

The Zara Company has one million ordinary shares outstanding, which currently trade at a price of $50. The company believes that its shareholders require a 15% return on their investment. The company also has a $47.1 million (face value) in five-year, fixed rate bonds with a coupon rate of 8% and a yield to maturity of 7%. Because the yield on these bonds is less than the coupon rate, they trade at a premium. Tax rate applicable on the company is 30%. Lastly, the company has 200,000 outstanding preferred shares, which pay an $8 annual dividend and currently sell for $80 per share.

1) What is the market value of the ordinary shares?

2) What is the cost of ordinary shares?

3) What is the after tax cost of debt?

4) What is the current market value of the bond? (Round your answer to whole number.)

5) What is the current market value of preference shares?

6) What is the cost of preference shares?

7) What is the Weighted Average Cost of Capital?

8) Explain Ordinary Shares and its characteristics.

9) Explain its any two advantages and disadvantages to the company.

Answer 1

1. Market value of ordinary shares=Outstanding shares*Share price=1 million*$50=$50 million

2. Cost of ordinary shares=shareholder's required rate of return=15%

3. After tax cost of debt=yield to maturity*(1-tax rate)=7%*(1-30%)=4.9%

4. Current market value of the debt needs to found using PV function in EXCEL

=PV(rate,nper,pmt,fv,type)

rate=7%

nper=maturity time=5

pmt=coupon payment=coupon rate*face value=(8%*$47.1 million)=$3.768 million

fv=face value=$47.1 million

=PV(7%,5,3.768,47.1,0)=$49.03 million

Market value of the debt=$49.03 million

5. Current market value of preferred shares=Outstanding shares*price=200,000*80=$16 million

6. Cost of preferrence shares=annual dividend/Share price=$8/$80=10%

7. WACC=(Weight of ordinary shares*cost of ordinary shares)+(weight of debt*after tax cost of debt)+(weight of preferrence shares*cost of preferrence shares)

Total value=Market value of ordinary shares+Market value of debt+market value of preferred shares=$50+$49.03+$16=$115.03 million

Weight of ordinary shares=$50/$115.03=43.47%

Weight of debt=$49.03/$115.03=42.62%

Weight of preferrence shares=$16/$115.03=13.91%

WACC=(43.47%*15%)+(42.62%*4.9%)+(13.91%*10%)=10.0%

8. Ordinary shares are the portion that the investors can buy a stake in the company. The characterstics are these will give the voting rights for the ordinary shareholdr's, will recieve the dividends from the company, can claim on the company's assets in the case of liquidation, these instruments does not have any maturity date.

9. the major disadvantages of ordinary shares are they are highly suspectible for the operational risk of the company. Any issues regarding the profits could eat way their dividends. Another thing is shareholders can claim the assets of the company only after the debt, preferred stocck holders were paid.