Question

Bonds: The company issued 80,000 bonds. The bonds have a $1,000 face value with 7.5% coupons with annual payments, 7 years to maturity, and currently sell for $925. The marginal tax rate is 12%.

Common Stock: The company has 500,000 shares of common stock outstanding, selling for $41 per share. The company’s beta is 1.25, the risk free rate is 2%, and the market risk premium is 9%.

Preferred Stock: The company issued 100,000 shares of preferred stock. Preferred stock pays a dividend of $1 per share, and preferred stock sells for $12 per share.

1. What is the market value of the firm’s debt?

2. What is the market value of the firm’s common stock?

3. What is the market value of the firm’s preferred stock?

4. What is the market value of the firm?

5. What percent of the firm is finance with debt?

6. What percent of the firm is financed with common stock?

7. What percent of the firm is financed with preferred stock?

8. What is the cost of debt before taxes? What is the cost of debt after taxes?

9. What is the cost of common stock? What is the cost of preferred stock?

10. What is the weighted average cost of capital?

Answer 1

(1): Market value of debt = 80,000 bonds*$925 = $74,000,000

(2): Market value of common stock = 500,000 shares * $41 = $20,500,000

(3): Market value of preferred stock = 100,000 shares * $12 = $1,200,000

(4): Market value of firm = 74,000,000 + 20,500,000 + 1,200,000

= $95,700,000

(5): % of firm financed with debt = 74,000,000/95,700,000 = 77.32%

(6): % of firm financed with common stock = 20,500,000/95,700,000 = 21.42%

(7)L % of firm financed with preferred stock = 1,200,000/95,700,000 = 1.25%

(8): Cost of debt = yield to maturity. Here FV = 1,000. PV = 925 and pmt = 7.5% of 1000 = $75. Nper = 7. Thus yield to maturity can be computed using the “rate” function in excel.

The formula is: RATE (7, 75, -925, 1000). This gives a value of 8.99%

Thus cost of debt before tax = 8.99%

Cost of debt after tax = 8.99%*(1-12%)

= 7.91%

(9): Cost of common stock = risk free rate + beta*market premium

= 2%+(1.25*9%)

= 13.25%

Cost of preferred stock = dividend/price = 1/12

= 8.33%

(10): WACC = (7.91% * 77.32%) + (13.25%*21.42%) + (8.33%*1.25%)

= 9.06%