Question

Crown Hill Berhad has a target capital structure consisting of debt (bond), preferred stock, and common stock. The capital structure for Crown Hill Berhad is as follows:

             Source of Capital                  Market Value

             Debt (bond)                            RM500,000

             Preferred Stock                      RM300,000

             Common Stock                      RM700,000

Debt

Crown Hill Berhad’s bond have a 12 percent coupon rate paid annually, with maturity period of 15 years and sells for RM1,050. The company’s marginal tax rate is 34 percent.

Preferred Stock

The preferred stock could sell at RM120 per share, annual dividend were RM9.80 per share.

Common Stock

The closing price for Crown Hill Berhad common stock is RM49 per share. Last year the company has paid a dividend of RM1.30. Dividend are expected to grow at a rate of 9 percent per year.

Required;

1. Calculate the frim’s capital stucture weights on a market value basis.

                                                                                                                            

                                                                                                                  (CLO3:PLO2:C3)

2. If the Crown Hill is evaluating a new investment project that has the same risk as the firm’s typical project, determine the rate should the firm used to discount (weightage average cost of capital) the project’s cash flows?

                                                                                                                             

                                                                                                                 (CLO3:PLO2:C3)

3. The company’s president has approached you about Crown Hill’s capital structure. He wants to know why the company doesn’t used more preferred stock financing because it costs less than debts. What would you tell the president?

                                                                                                                                       

                                                                                                                         (CLO3:PLO2:C3)                                                     

Answer 1

1. Firm’s capital stucture weights on a market value basis:

~ Total Market Value of all =  RM500,000 +  RM300,000 +  RM700,000 = RM1,500,000

~ Weight of Debt = RM500 / RM1500 = 33.33%

~ Weight of Preferred Stock = RM300 / RM1500 = 20%

~ Weight of Common Stock = RM700 / RM1500 = 46.67%

2. The rate the firm should use to discount (weightage average cost of capital):

~ Cost of Debt:

FV = 1000

PV = -1050

PMT = 1000 x 12% = 120

N = 15

Inputting these values in the financial calculator, then "CPT", "I/Y", we get,

I/Y = Cost of Debt = 11.29%

~ Cost of Preferred Stock:

Preferred Stock Price = Annual Dividend / r

120 = 9.80 / r

r = 0.08166

Therefore, r = Cost of Preferred Stock = 8.16%

~ Cost of Equity:

Stock Price = Dividend₀ (1 + g) / (r - g)

Therefore,

r = [Dividend₀ (1 + g) / Stock Price] + g

= [ (1.30)(1.09) / 49] + 0.09

r = 0.1189

Therefore, r = Cost of Equity = 11.89%

~ WACC:

= (Weight of Debt)(Cost of Debt)(1 - tax) + (Weight of Preferred)(Cost of Preferred) + (Weight of Equity)(Cost of Equity)

= (0.3333)(11.29%)(1 - 0.34) + (0.20)(8.16%) + (0.4667)(11.89%)

= 2.48% + 1.632% + 5.55%

= 9.66%

Therefore, the Weighted Average Cost of Capital = 9.66%

3. He wants to know why the company doesn’t used more preferred stock financing because it costs less than debts. What would you tell the president?

~ The cost of debt is the interest paid to the debt holders. The interest on debt capital is tax deductible for the company. Hence, the company pays less taxes as a result of interest deduction from the profits.

~ Therefore, the cost of debt that should be considered is "After Tax Cost of Debt."

~ Therefore, After Tax Cost of Debt is (11.29%) (1 - 0.34) = 7.45%

~ The cost of preferred stock is 8.16%.

~ Therefore, After Tax Cost of Debt (7.45%) is less than the Cost of Preferred Stock (8.16%). This is the reason why the company is not using more preferred stock than debt.