Question

 

The firm decides to raise $30 million by selling equity and debt. The investment bankers hired by your firm contact potential investors and come back with the following numbers:

Debt that pays $1 million each year for 10 years and pays $18 million at maturity currently sells for $20 million.

Equity that pays expected dividends of $1.2 million starting next year and growing at a rate of 3 percent per year thereafter sells for $10 million.

Assume the firm’s tax rate is 30%.

Question 12: Calculate the cost of debt, equity, and the WACC.

Your firm has decided to spin off Android01 and Processor01 as a separate firm. The owners of the new firm will be equity holders and debt holders. After speaking with potential investors, investment banks have identified two possible capital structures (structure of equity and debt ownership):

Debt holders receive debt that pays them coupons of $2 million a year, and $30 million after 20 years (these are expected values as the coupons and principal payments are not riskless, the debt buyers realize the firms could default). They price the debt using a discount rate (required rate of return) of 4 percent. Equity holders receive expected dividends of $3 million starting from year 5, and growing at a rate of 4 percent per year (a growing perpetuity). They price the equity using a discount rate (required rate of return) of 7.5 percent.

Debt holders receive debt that pays them coupons of $1 million a year, and $12 million after 20 years (these are expected values as the coupons and principal payments are not riskless, the debt buyers realize the firms could default). They price the debt using a discount rate (required rate of return) of 3.5 percent. Equity holders receive expected dividends of $3.9 million starting from year 5, and growing at a rate of 4.5 percent per year (a growing perpetuity). They price the equity using a discount rate (required rate of return) of 7 percent.

Your firm receives all the proceeds from the sale debt and equity. Since the firm is selling debt and equity, it wants to sell using the capital structure that provides them with the most money (sum of whatever debt and equity sells for).

Question 13: Which particular capital structure should be chosen for the spin-off?

Answer 1

question 12)

I have firstly, stated all the given information in the question required to solve it such as the total amount raised, value of debt and equity

now , you know that formula for WACC

WACC = [w1*k1*(1-t)] + [ w2*k2]

where:

w1 = proportion of debt in the capital structure

k1 = cost of debt before tax

t = tax rate

w2 = proportion of equity in capital structure = 1-w1

k2 = cost of equity

so now , for WACC , we need to calculated the capital structure weights , w1,w2

and the individual costs for debt and equity

Now cost of debt has been calculated using the excel function "RATE"

which requires inputs such as : nper = maturity of debt

, amt : annuity amount paid on debt = coupon / interest on debt

pv : present value or the value today ( negative sign is required to enter this value )

fv: future value or maturity value of debt

this will give you before tax cost of debt ,

since the actual cost of debt is after tax cost of debt , we multiply the above value of rate with (1-t)

Now,

to get the cost of equity , I have used the constant growth dividend model

where; cost of equity = (D1/P0) + g

where D1 = expected value of dividends

P0 = current value of equity

g = growth rate of dividends per year

after calculating individual cost , we will use the WACC formula stated above to compute the required WACC