Question

Suppose there is a corporate bond. Its face value is $2000. And the maturity is 4 years. Its coupon is $10 issued at the end of each year. Its price is $1900 right now. The interest rates for bonds and stocks are 2% and 3%, respectively. The market price of stock of this company is $25 right now. And the shares outstanding is 25,000 shares. And the tax rate is 20%. The ratio of debt to equity is 0.2.

a. What is the WACC for this firm?

b. What are the NPV and the YTM of the bond?

c. Suppose the firm is going to repurchase some stocks now. It repurchased 5000 shares from the market at the current price. What is the stock price after the repurchase?

d. Suppose the firm is going to split its stock. It is a 2-to-1 split. It requires commission of $ 2000. What is the stock price afterwards?

e. Suppose the firm issued cash dividend of $2 per share. What is the price afterwards?

Answer 1

a.

D/E	0.2
V/E	1.2
E/V	0.83
D/V	0.17
Ke	3%
Kd	2%
tax	20%
WACC	2.77%

b.

Solving for YTM which is also the IRR of the bond gives us 1.81%. At this YTM, the NPV of the bond is zero. Remember that YTM is also the IRR of the bond and IRR is the rate at which NPV becomes zero.

c.

Under perfect market conditions share repurchase should not affect the price. Hence, the price remains to be $25. Or, you can calculate as after repurchase the shares remaining are 20000 and the share price= (25*25000-25*5000)/20000= $25

d.

2:1 split makes the stock price half. $25*1/2=$12.5. However, it also has flotation cost. So, with the stock split the aggregate value will not change in the absence of transaction costs. However, number of shares and share price will change.

Total equity value now= $625000-$2000 commission= $623000

Total shares available now= 25000*2 split= 50000

Hence, new price should be= $623000/50000= $12.46

e.

Under perfect capital markets, the share price after the dividend is the ex-dividend price= $25-$2=$23