Question

In: Finance

Question 5 (20 marks) (a) (b) TLT company has $720 million in common stock outstanding. Its...

Question 5

(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)

Solutions

Expert Solution

Answer 5 b)

Given
TLT company

i)

Value of equity = value of common shares outstanding = $ 720 million
Cost of equity = 12 %
Value of debt = value of bonds = $ 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 %
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 can change because of  flotation cost. The cost incurred in issuing new equity are termed as the flotation costs. It ranges from 2-3 % of the total issue.

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 match 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 and increasing the shareholders wealth.The dividend policies are at the whole discretion of management and company can alter the dividend policies depending on economic environment and company performance.


Related Solutions

(a) (b) TLT company has $720 million in common stock outstanding. Its cost of equity is...
(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...
OMG Inc. has 6 million shares of common stock outstanding, 5 million shares of preferred stock...
OMG Inc. has 6 million shares of common stock outstanding, 5 million shares of preferred stock outstanding, and 7,000 bonds. Suppose the common shares sell for $17 per share, the preferred shares sell for $16 per share, and the bonds sell for 108 percent of par. What weight should you use for preferred stock in the computation of OMG’s WACC? (Round your answer to 2 decimal places.)
A company has 14 million shares of common stock outstanding with a beta of 1.15 and...
A company has 14 million shares of common stock outstanding with a beta of 1.15 and a market price of $45 a share. There are 1000000 shares of 9 percent preferred stock outstanding valued at $80 a share. The 10 percent semi annual coupon bonds have a face value of $1000 and are selling at 92 percent of par. There are 280,000 bonds outstanding that mature in 15 years. The market risk premium is 12 percent., T-bills are yielding 4.5...
A company has 14 million shares of common stock outstanding with a beta of 1.15 and...
A company has 14 million shares of common stock outstanding with a beta of 1.15 and a market price of $45 a share. There are 1,000,000 shares of 9 percent preferred stock outstanding valued at $80 a share. The 10 percent semiannual coupon bonds have a face value of $1,000 and are selling at 92 percent of par. There are 280,000 bonds outstanding that mature in 15 years. The market risk premium is 12 percent, T-bills are yielding 4.5 percent,...
Titan Mining Corporation has 8 million shares of common stock outstanding, 5 million shares of preferred...
Titan Mining Corporation has 8 million shares of common stock outstanding, 5 million shares of preferred stock outstanding, and 100,000 units of 9 percent semiannual bonds outstanding, par value $1,000 each. The preferred stock pays a dividend of $6 per share. The common stock currently sells for $32 per share and has a beta of 1.15, the preferred stock currently sells for $67 per share, and the bonds have 15 years to maturity and sell for 91 percent of par....
Titan Mining Corporation has 8 million shares of common stock outstanding, 5 million shares of preferred...
Titan Mining Corporation has 8 million shares of common stock outstanding, 5 million shares of preferred stock outstanding, and 100,000 units of 9 percent semiannual bonds outstanding, par value $1,000 each. The preferred stock pays a dividend of $6 per share. The common stock currently sells for $32 per share and has a beta of 1.15, the preferred stock currently sells for $67 per share, and the bonds have 15 years to maturity and sell for 91 percent of par....
A company has 4.3 million shares of common stock outstanding and 85,000 bonds outstanding, par value...
A company has 4.3 million shares of common stock outstanding and 85,000 bonds outstanding, par value of $1,000 each. Each bond has a 6.8 percent annual coupon rate and the bonds have 23 years to maturity and is now selling at $789.23. (Based on the current price, its YTM is 9%) Coupon is paid annually. The common stock currently sells for $58.00 per share and has a beta of 0.90.  The market risk premium is 7 percent and Treasury bills are...
Celom has 5 million shares of common stock outstanding with a current price per share of...
Celom has 5 million shares of common stock outstanding with a current price per share of $15 per share. The company has 2 million shares of preferred stock outstanding with a current price of $20 per share. The company also has 5,000 bonds outstanding with a par value of $1,000 each and a coupon rate of 6%. The bonds are quoted at 102. What weightings should Celom use for its WACC calculation? Therbo Inc's market weighing's of its debt, preferred...
ABC Industries has 5 million shares of common stock outstanding with a market price of $20.00...
ABC Industries has 5 million shares of common stock outstanding with a market price of $20.00 per share. The company also has 1 million shares outstanding preferred stock with a market price of $8.50 per share, and 200,000 bonds outstanding, each with a face vale $1,000 and selling at 97.5% par value. The cost of equity is 12%, the cost of preferred is 10%, and the cost of debt is 7.46%. If ABC's tax rate is 34% what is the...
Question 3 [20 marks] Western Mining has debt outstanding of $300 million in market value, consisting...
Question 3 [20 marks] Western Mining has debt outstanding of $300 million in market value, consisting of 7% coupon bonds with a maturity of 10 years. The bonds pay semi-annual coupons with a face value of $1,000 and priced at $1,024.87 each. The company also has 2 million preference shares outstanding with a market price of $20 each, paying an annual dividend of $1.05. It has 14 million ordinary shares outstanding, priced at $21.00 a share. The company is expected...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT