Question

Problem 13-7 WACC (LO1)

Examine the following book-value balance sheet for University Products Inc. The preferred stock currently sells for $30 per share and pays a dividend of $3 a share. The common stock sells for $20 per share and has a beta of 0.8. There are 2 million common shares outstanding. The market risk premium is 10%, the risk-free rate is 5%, and the firm’s tax rate is 40%.

BOOK-VALUE BALANCE SHEET
(Figures in $ millions)
Assets					Liabilities and Net Worth
Cash and short-term securities	$	2.0			Bonds, coupon = 5%, paid annually (maturity = 10 years, current yield to maturity = 6%)	$	10.0
Accounts receivable		6.0			Preferred stock (par value $10 per share)		3.0
Inventories		10.0			Common stock (par value $0.10)		0.2
Plant and equipment		23.0			Additional paid-in stockholders’ equity		19.8
					Retained earnings		8.0
Total	$	41.0			Total	$	41.0

a. What is the market debt-to-value ratio of the firm? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

b. What is University’s WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Answer 1

Debt
		6%
Year	Cash Flow	PV fatctor = 1/ (1+r)^t	PV
0		1.000	-
1	500,000	0.943	471,698
2	500,000	0.890	444,998
3	500,000	0.840	419,810
4	500,000	0.792	396,047
5	500,000	0.747	373,629
6	500,000	0.705	352,480
7	500,000	0.665	332,529
8	500,000	0.627	313,706
9	500,000	0.592	295,949
10	500,000	0.558	279,197
10	10,000,000	0.558	5,583,948
		NPV	9,263,991
So this NPV will be the market value of debt
Cost	6%
Tax	40%
Cost of debt after tax	6% * (1-40%)	3.60%
Preferred Stock
No of shares	3000000/10	300,000
Market Price	30
Market Value	300000*30	9,000,000
Dividend per share	3
Total dividend	300000*3	900,000
Cost=	900000/9000000	10.00%
Equity Stock
No of shares	2,000,000
Market Price	20
Market Value	2000000*20	40,000,000
Cost=	Risk free rate + Beta * Market risk premium
Cost=	5% + 0.8 * 10%
Cost=	13.00%
Based on Market Values
Component	Cost	Capital	Weight	Cost * Weight
Debt	3.60%	9,263,991	15.90%	0.57%
Preferred Stock	10.00%	9,000,000	15.45%	1.54%
Equity	13.00%	40,000,000	68.65%	8.92%
		58,263,991	WACC	11.04%