Question

(a)
(b)
TLT company has $720 million in common stock outstanding. Its cost of
equity is 12%. Moreover, TLT has $360 million in 6% coupon rate bonds
outstanding. The bond is currently sold at par. There are no taxes in the
country in which TLT company operates.
i. Calculate the weighted average cost of capital (WACC) of TLT.
ii. TLT has decided to issue $180 million in common stock and use the
proceeds to buy back its bonds. According to the Modigliani & Miller
(M&M) propositions, what are the TLT’s new WACC and new cost of
equity?
Critically discuss the importance of dividend clientele effect to the firm
value. (word limit: 150 words)

Answer 1

Answer:-

Given for TLT company

Value of equity = $ 720 million
Cost of equity = 12 %
Value of debt = $ 360 million
Cost of debt = 6 %
Tax rate = 0 %
Wt of equity = value of equity / ( value of equity + value of debt) = $ 720 m / ( $ 720 m + $ 360 m ) = $ 720 m / $ 1080 m = 0.667
Wt of debt = value of debt  / ( value of equity + value of debt) = $ 360 m / ( $ 720 m + $ 360 m ) = $ 360 m / $ 1080 m = 0.333

WACC = wt of equity x cost of equity + wt of debt x cost of equity x ( 1 - tax rate)
WACC = 0.667 x 12 % + 0.333 x 6 % x ( 1 - 0 %)
WACC = 8 % + 2 % = 10 %

Therefore WACC of TLT = 10 %

ii)

The new equity of $180 million is issued and the proceeds are used to buy back bonds

Therefore the new equity = $ 720 m + $ 180 m = $ 900 million
The new debt after buy back of bonds = $ 360 - $ 180 = $ 180
Wt of equity = $ 900 m / ( $ 900 m + $ 180 m) = $ 900 m / $ 1080 m = 0.833
Wt of debt = $ 180 m / ( $ 900 m + $ 180 m ) = $ 180 / $ 1080 =  0.1667
Therefore WACC = 0.833 x 12 % + 0.1667 x 6 % ( 1 - 0%)
WACC = 10 % + 1 % = 11 %
Therefore the WACC of TLT under the new capital structure = 11 %

The new cost of equity is increased taking into consideration the flotation cost. The cost incurred in issuing new equity are termed as the flotation costs.

Q) Importance of dividend clientele effect to the firm value

The dividends clientele effects shows the expectation of the shareholders for how much the company pays in dividends. The investment objective of many investors are mostly aligned to the dividends paid by the company. There are times when the companies adopt dividend policies to soothe the demands of the shareholders. As the company grows the earnings grow and the expectation of dividends aligned with the prospects of the company increases. There are some companies that pays dividends in line with earnings while there are others who pay fixed amount of dividends irrespective of earnings growth. The companies sometimes do not pay dividends and the whole earnings are invested in new profitable projects which increases the value of the firm thus leading to the increase in stock price thus increasing the shareholders wealth.The dividend policies are at the whole discretion of management and sometimes there is change in dividend policy which takes after lot of deliberations and discussions.