Question

QUESTION 1

In year 2015, ABC Inc. has the following capital structure:

Type of Financing	Characteristics
Bonds	Coupon interest rate: NO INTEREST (ZERO- COUPON) Market price: SR375 Par Value:SR1,000 Maturity: 10 years Tax bracket: 35% Total Market Value: SR375,000
Preferred Stock	Dividend: SR2.15 Market price: SR20 Total Market Value: SR210,000
Common Stock	Dividend paid last year: SR4.50 Market price: SR35 Dividend growth: 6% Total Market Value: SR415,000

The corporation has decided to expand by selling more common stock. Based on the information in the table above,

1. Given the total market value of each type of financing in the table above, calculate the weight of each type of financing component. Show your calculations in the table below.

Type of financing	Total Market Value	Weight (W)
Bonds
Preferred Stock
Common Stock
TOTAL

2. Calculate the cost for each capital component.

i- Cost of debt (bond). Calculate cost of debt before tax, kd and cost of debt after tax, ki

ii-Cost of preferred stock.

iii-Cost of common stock (common equity)

a-Retained earnings

b-New issue of common equity if the floatation cost is SR1.50 per share.

c- Calculate the weighted average cost of capital (WACC) for ABC Inc. if the corporation wants to finance using new common equity.  

d- If the corporation has an investment projects with a return of 10.5%, should it invest in that project or not. Explain your answer.

Answer 1

A]

The weights are calculated below :

The weights are calculated below :

A]

i]

before tax cost of debt = YTM of bond

price of zero coupon bond = face value / (1 + YTM)years to maturity

375 = 1,000 / (1 + YTM)10

YTM = (1,000 / 375)1/10 -1

YTM = 10.31%

after tax cost of debt = before tax cost of debt * (1 - tax rate)

after tax cost of debt = 10.31% * (1 - 35%)

after tax cost of debt = 6.70%

ii]

Cost of preferred stock = dividend / share price

Cost of preferred stock = 2.15 / 20 = 10.75%

iii]

a]

cost of Retained earnings = (next year dividend / share price) + growth rate

next year dividend = last year dividend * (1 + growth rate)

cost of Retained earnings = ((4.50 * (1 + 6%) / 35) + 6%

cost of Retained earnings = 19.63%

b]

cost of new common equity = (next year dividend / net proceeds per share) + growth rate

net proceeds per share = share price - flotation costs = 35 - 1.50 = 33.50

cost of new common equity = ((4.50 * (1 + 6%) / 33.50) + 6%

cost of new common equity = 20.24%

c]]

WACC = (weight of debt * cost of debt) + (weight of preferred stock * cost of preferred stock) + (weight of common stock * cost of common stock)

WACC = (37.50%* 6.70%) + (21.00% * 10.75%) + (41.50% * 20.24%)

WACC = 13.17%

d]

NO, it should not invest because the rate of return on the project is lower than the WACC