Question

The following table gives the current balance sheet for Travellers Inn Inc. (TII), a company
that was formed by merging a number of regional motel chains.
Travellers Inn (Millions of Dollars)
Cash $ 10 Accounts payable $ 10
Accounts receivable 20 Accruals 15
Inventories 20 Short-term debt 0
Current assets $ 50 Current liabilities $ 25
Net fixed assets 50 Long-term debt 30
Preferred stock (50,000 shares) 5
Common equity
Common stock (3,800,000 shares $ 10
Retained earnings 30
Total common equity $ 40
Total assets $100 Total liabilities and equity $100
The following facts also apply to TII.
(1) The long-term debt consists of 29,412 bonds, each having a 20-year maturity, semiannual
payments, a coupon rate of 7.6%, and a face value of $1,000. Currently, these
bonds provide investors with a yield to maturity of 11.8%. If new bonds were sold,
they would have an 11.8% yield to maturity.
(2) TII’s perpetual preferred stock has a $100 par value, pays a quarterly dividend per
share of $2, and has a yield to investors of 10%. New perpetual preferred stock would
have to provide the same yield to investors, and the company would incur a 3.85%
flotation cost to sell it.
(3) The company has 3.8 million shares of common stock outstanding, a price per share 5
P0 5 $20, dividend per share 5 D0 5 $1, and earnings per share 5 EPS0 5 $5. The
return on equity (ROE) is expected to be 10%.
(4) The stock has a beta of 1.6%. The T-bond rate is 6%, and RPM is estimated to be 5%.
(5) TII’s financial vice president recently polled some pension fund investment managers
who hold TII’s securities regarding what minimum rate of return on TII’s common
would make them willing to buy the common rather than TII bonds, given that
the bonds yielded 11.8%. The responses suggested a risk premium over TII bonds of
3 percentage points.
(6) TII is in the 25% federal-plus-state tax bracket.
Assume that you were recently hired by TII as a financial analyst and that your boss,
the treasurer, has asked you to estimate the company’s WACC under the assumption
that no new equity will be issued. Your cost of capital should be appropriate for use in

on your analysis, answer the following questions.
a. What are the current market value weights for debt, preferred stock, and common
stock? (Hint: Do your work in dollars, not millions of dollars. When you calculate
the market values of debt and preferred stock, be sure to round the market price per
bond and the market price per share of preferred to the nearest penny.)
b. What is the after-tax cost of debt?
c. What is the cost of preferred stock?
d. What is the required return on common stock using CAPM?
e. Use the retention growth equation to estimate the expected growth rate. Then use
the expected growth rate and the dividend growth model to estimate the required
return on common stock.
f. What is the required return on common stock using the own-bond-yield-plusjudgmental-
risk-premium approach?
g. Use the required return on stock from the CAPM model, and calculate the WACC.

Answer 1

a]

Current price of each bond is calculated using PV function in Excel :

rate = 11.8% / 2 (converting annual YTM into semiannual YTM)

nper = 20 * 2 (total number of semiannual coupon payments = years to maturity * 2)

pmt = 1000 * 7.6% / 2 (semiannual coupon payment = face value * annual coupon rate / 2)

fv = 1000 (face value receivable at maturity)

PV is calculated to be $680

market value of debt = price per bond * number of bonds outstanding = $680 * 29,412 = $20,000,270

yield on preferred stock = annual dividend / price per share

10% = ($2 * 4) / price per share

price per share = $8 / 10% = $80

market value of preferred stock = price per share * number of shares outstanding = $80 * 50,000 = $4,000,000

market value of common equity = price per share * number of shares outstanding = $20 * 3,800,000 = $76,000,000

total market value =  $20,000,270 + $4,000,000 + $76,000,000 = $100,000,270

market value weight of debt =  market value of debt / total market value = $20,000,270 / $100,000,270 = 0.20

market value weight of preferred stock =  market value of preferred stock / total market value = $4,000,000 / $100,000,270 = 0.04

market value weight of common stock =  market value of common stock / total market value = $76,000,000 / $100,000,270 = 0.76

b]

after tax cost of debt = YTM * (1 - tax rate) = 11.8% * (1 - 25%) = 8.85%

c]

cost of preferred stock = annual dividend / net proceeds per share

net proceeds per share = price per share * (1 - flotation cost) = $80 * (1 - 3.85%) = $76.92

cost of preferred stock = $8 / $76.92 = 10.40%

d]

required return = risk free rate + (beta * market risk premium)

required return = 6% + (1.6 * 5%) = 14%