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.

                                                                                                                             (

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?

                                                                                                                      

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?

Answer 1

1) The firm capital structure is as follows:

Debt = 500,000

Preferred stock =300,000

Common stock = 700,000

Total = 1,500,000

Market value weight = Individual value / Total

               Debt = 500,000 / 1,500,000

                         =33.33%

Preferred stock = 300,000 / 1,500,000

                          = 20.00%

Common stock = 700,000 / 1,500,000

                         = 46.67%

2) Calculate the before tax cost of bonds by using rate function in MS excel

                                        = RATE (nper,pmt,pv,fv,type)

                                        =RATE(15,1000*12%,-1050,1000,0)

                                       = 11.29%

Here,

nper =15

pmt =1000*12%

pv = -1050

fv =1000

type =0

                                                

           After tax cost of bonds = rate *(1- tax rate)

                                                = 11.29*(1-.34)

                                               = 7.45

Cost of preferred stock= Annual dividend/market price

                                     = 9.80/120

                                     = 8.17%

Cost of common stock = (Expected dividend/market price)+growth rate

                                   = (1.417/49) + 9%

                                   = 11.89%

Expected dividend = Dividend paid last year *(1+growth rate)

                              = 1.30*(1+.09)

                               = 1.417

WACC = Sum of market value of weight * component cost of capital

                 Debt = 33.33% * 7.45 = 2.483085

Preferred stock = 20.00% * 8.17= 1.634

Common stock = 46.67% * 11.89= 5.549063

WACC = 2.483085 + 1.634 + 5.549063

            = 9.666148 or 9.67(Approx)

3) As the debt cost before the tax is 11.29% and of preferred stock is 8.17%, which shows the cost of debt is more, but the interest expense paid on debt is deductible which then actually comes down to 7.45%. Now the debt cost is less than the preferred stock. Therefore, it is recommended to issue the bonds rather than preferred stock.