Question

5. Santa Corp. has 5,000 zero-coupon bonds outstanding. The bonds have a face value of $1,000, 4 years to maturity, and are currently trading at $822.70. The firm also has 750,000 common shares outstanding. The shares are currently priced at $21.75 each and yesterday paid a dividend of $2.24. The firm’s most recent annual financial statements show net income of $2.80 mln, shareholders’ equity of $26.67 mln, and a marginal tax rate of 26%.

   1. What are the weights of debt and equity in Santa Corp.’s capital structure? [2 points]

   2. What is Santa Corp.’s required return on equity? [4 points]

   3. What is Santa Corp.’s weighted average cost of capital? [4 points]

Answer 1

ROE = Net income/total equity

ROE% = 2.8/26.67

ROE% = 10.5

Dividend payout = DPS/EPS =  dividend*number of shares/net income = 2.24*750000/2800000 = 0.6

Growth rate=ROE*(1-payout ratio)

growth rate=10.5*(1-0.6)

growth rate = 4.2

MV of equity=Price of equity*number of shares outstanding

MV of equity=21.75*750000

=16312500

MV of Bond=Par value*bonds outstanding*%age of par

MV of Bond=1000*5000*0.8227

=4113500

MV of firm = MV of Equity + MV of Bond

=16312500+4113500

=20426000

Weight of equity = MV of Equity/MV of firm

Weight of equity = 16312500/20426000

W(E)=0.7986 = 79.86%

Weight of debt = MV of Bond/MV of firm

Weight of debt = 4113500/20426000

W(D)=0.2014 = 20.14%

Cost of equity

As per DDM

Price = recent dividend* (1 + growth rate )/(cost of equity - growth rate)

21.75 = 2.24 * (1+0.042) / (Cost of equity - 0.042)

Cost of equity% = 14.93 =required return on equity

Cost of debt

K = N

Bond Price =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =4

822.7 =∑ [(0*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^4

k=1

YTM = 5.0000789636

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 5.0000789636*(1-0.26)

= 3.700058433064

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=3.7*0.2014+14.93*0.7986

WACC =12.67%