Question

WACC Estimation The table below gives the balance sheet for Travelers Inn Inc. (TII), a company that was formed by merging a number of regional motel chains. Travelers Inn: December 31, 2015 (Millions of Dollars) Cash $10 Accounts payable $10 Accounts receivable 20 Accruals 10 Inventories 20 Short-term debt 5 Current assets $50 Current liabilities $25 Net fixed assets 50 Long-term debt 30 Preferred stock 5 Common equity Common stock $10 Retained earnings 30 Total common equity $40 Total assets $100 Total liabilities and equity $100 The following facts also apply to TII: Short-term debt consists of bank loans that currently cost 10%, with interest payable quarterly. These loans are used to finance receivables and inventories on a seasonal basis, so bank loans are zero in the off-season. The long-term debt consists of 25-year, semiannual payment mortgage bonds with a coupon rate of 9%. Currently, these bonds provide a yield to investors of rd= 12%. If new bonds were sold, they would have a 12% yield to maturity. TII's perpetual preferred stock has a $100 par value, pays a quarterly dividend of $2.50, and has a yield to investors of 9%. New perpetual preferred stock would have to provide the same yield to investors, and the company would incur a 7% flotation cost to sell it. The company has 4 million shares of common stock outstanding. P0 = $20, but the stock has recently traded in the price range from $17 to $23. D0 = $1 and EPS0 = $2. ROE based on average equity was 25% in 2008, but management expects to increase this return on equity to 29%; however, security analysts and investors generally are not aware of management's optimism in this regard. Betas, as reported by security analysts, range from 1.3 to 1.7; the T-bond rate is 9%; and RPM is estimated by various brokerage houses to range from 4.5% to 5.5%. Some brokerage house analysts report forecasted dividend growth rates in the range of 10% to 15% over the foreseeable future. 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 12%. The responses suggested a risk premium over TII bonds of 4 to 6 percentage points. TII is in the 30% federal-plus-state tax bracket. TII's principal investment banker predicts a decline in interest rates, with rd falling to 10% and the T-bond rate to 7%, although the bank acknowledges that an increase in the expected inflation rate could lead to an increase rather than a decrease in interest rates. 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 evaluating projects that are in the same risk class as the assets TII now operates. Do not round intermediate steps. Round your answer to two decimal places.

Answer 1

The weighted average cost of capital of Travelers Inn Inc.under the assumption that no new equity will be issued is 15.01%

CALCULATION

NOTE:- short-term debt is used to finance seasonal goods, and the balance is reduced to zero in off-seasons. Therefore, this is not a source of permanent financing. and should be disregarded when calculating the WACC.

WACC Calculation

1).Market Value Calculation

Debt: Rate= 12%/2

periods (25*2)= 50

FV (Face Value)= 1000

PMT(9%/2)* 1000= 45

Market Value of Long term Debt PV =(.12/2,50,-.9/2,-1000,0) = $763.57

Total value of Debt(763.57/1000)*30*1000000 = 22907162.71

Preferred Stock:

Price per share =(2.50/(.10/4)) = 100.00

shares of preferred outstanding = 50000

Total market value of the preferred is 5000000

Common Stock:

The market value of the common stock is 4,000,000($20) 80000000

2. Calculation of Weights

Firm's market value capital structure Weight Weight

Long-term debt 22907162.71 22907162.71 / 107907162.7 21%

Long-term debt 5000000 5000000 / 107907162.7 5%

Preferred stock 80000000 80000000 / 107907162.7 74%

Total 107907162.7 100%

3. calculation of costs

Debt cost: rd(1 - T) =12%(1-.30) 8.40%

Preferred cost: Annual dividend on new preferred =10%*100 =10 =10/(100*(1-7%)) = 10.75%

a.Cost of Equity-CAPM:

T-bond rate 9%

beta 1.3 to 1.7

RPM 4.5% to 5.5%

Midpoint CAPM

T-bond rate 9%

beta 1.5

RPM 5% a

CAPM Cost of Equity (9% + (1.5 *5%)) =16.50%

b.Cost of Equity -DCF Growt Rate = ROE*Dividend Payout =(25%*1/2)= 12.5%

analysts' forecasted g range, = 10 to 15 %

Cost of Equity -DCF =((1*(1+10.5%))/20)+((10%+15%)/2) =18.03%

c. Cost of Equity Generalized risk premium =12%+(4%+6%)/2 =17%

Cost of equity under Different Method

CAPM Cost of Equity 16.5%

Cost of Equity -DCF 18.03%

Cost of Equity Generalized risk premium 17%

Average of All Method(16.5%+18.03%+17%)/3 =17.18%

c.WACC

cost (C) weight (W) C *W

Debt 8.4% 21% 1.78%

Preffered cost 10.75% 5% .05%

cost of equity 17.18% 74% 12.73%

Total WACC 15.01%