Question

2. KLM Inc. just paid a dividend of $3.25 per share on 180,000 shares outstanding. Dividends are expected to grow at a constant rate indefinitely. The firm’s ROE is 12 percent, beta is 1.3 and the dividend payout ratio is 55 percent. Treasury notes are yielding 2.75 percent and the market risk premium is estimated at 7.25 percent. The firm has 15,000 bonds outstanding that will mature in 6 years. The bonds are quoted at 105 percent of par and pay a 6.8 percent semi- annual coupon. The firm’s tax rate is 21 percent. What is the change in the firm’s WACC if it sells 10,000 7-year zero coupon bonds ($1,000 par value) with an 8.2 percent market required rate of return, other costs of capital kept constant? Assume semi-annual compounding for the zero-coupon bonds. (10 points)

Answer 1

1]	Growth rate of dividends = ROE*Retention rate = 12%*(1-55%) =	5.40%
	Cost of equity using CAPM = risk free rate+beta*market risk premium = 2.75%+1.3*7.25% =	12.18%
	Market price of the share = 3.25*1.054/(0.1218-0.054) =	$             50.52
2]	Before tax cost of debt = YTM
	YTM using a financial calculator =	5.80%
	After tax cost of debt = 5.80%*(1-21%) =	4.58%
3]	WACC:
	Source of Capital	Market Value	Weight	Cost	WACC
	Debt [15000*$1050]	$ 1,57,50,000	63.40%	4.58%	2.90%
	Equity [180000*$50.52]	$     90,93,600	36.60%	12.18%	4.46%
	Total	$ 2,48,43,600	100.00%		7.36%
4]	Price of zero coupon bonds = 1000/1.041^14-1=	$           568.76
	After tax cost of zero coupon bond = 6.80%*(1-21%) =	5.37%
5]	New WACC:
	Source of Capital	Market Value	Weight	Cost	WACC
	Coupon bonds [15000*$1050]	$ 1,57,50,000	51.59%	4.58%	2.36%
	Zero bonds [10000*$568.76]	$     56,87,600	18.63%	5.37%	1.00%
	Equity [180000*$50.52]	$     90,93,600	29.78%	12.18%	3.63%
	Total	$ 3,05,31,200	100.00%		6.99%
6]	Change in firm's WACC = 7.36%-6.99% =	0.37%
		Decrease