Question

Question 3: Coca-Cola Corp. needs to purchase new plastic moulding machines to meet the demand for its product. The cost of the equipment is $3,028,000. It is estimated that the firm will increase after tax cash flow (ATCF) by $611,671 annually for the next 5 years. The firm is financed with 40% debt and 60% equity, both based on current market values, though the firm has announced that it wants to quickly change its debt to equity ratio to 1.5. The firm's beta is 1.24, the risk free rate is 3.82% and the expected market return is 7.23%. Coca-Cola Corp.'s semi-annual bonds have 11.80% coupons, 22 years to maturity, and a quoted price of 91.547. Assume the firm's tax rate is 34%. The firm's last 5 dividends (the last in the list is D0) are 1.23, 1.60, 2.04, 2.51, and 2.87. Its current market price is $107.06.

Question 3, Short Answer B: In calculating the firm's WACC, you had to make a couple of judgment calls. What were they and briefly discuss why you made the decisions you did.

Answer 1

Solution:

WACC is given by = (1/(1+DER)) * Cost of Equity + (1-1/(1+DER))*Cost of Debt

Cost of Equity = rf + beta *(rm – rf)

Cost of debt = Yield * (1- tax rate)

Current DE Ratio of the company = 4/6 = 0.67

As we can observe, the company is expected to borrow more debt than it has now as the targeted DE ratio is 1.5 as against current DE ratio of 0.67.

This will increase risk in the company and in turn will impact its beta. As the company plans to change to the targeted DE ratio ‘quickly’, we need to adjust the current beta of the company to that effect.

We do this by first calculating the unlevered beta of the company.

Unlevered Beta = Beta Levered/ (1+(1-tax rate)*DER) = 1.24/(1+(1-34%)*0.67) = 0.86

Relevering the Beta for the targeted DE Ratio of 1.5

Beta Levered = Beta Unlevered * (1+(1-taxrate)*DER) = 0.86*(1+(1-0.34)) = 1.42 (rounding to two decimals)

So,

Cost of Equity = 3.82% + 1.42 *(7.23%. - 3.82%) = 8.66%

Cost of Debt

To calculate yield, assuming FV of the bond to be $100

Yield of the Bond = 12.97% [ using RATE function =RATE(22*2,100*11.8%/2,-91.547,100)*2]

So Cost of Debt = 12.97% * (1- tax rate) = 12.97% *(1-0.34) = 8.56%

We are assuming here, that the company will be able to place new debt at this Yield. As DE ratios is increasing but still in the reasonable limit of 1.5, we are assuming that there may not be major change in the yield.

Therefore,

WACC = (1/(1+DER)) * Cost of Equity + (1-1/(1+DER))*Cost of Debt

                = (1/(1+1.5))*8.66% + (1-1/(1+1.5))*8.56% = 8.60%

NOTE: We have used targeted DE ratio of 1.5 in this calculation of WACC.

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