Question

Problem 2 ) This problem has 2 parts I & II

1. Ellay steel Corporation has 1.9 million shares of common stock outstanding, 50,000 shares of preferred stock outstanding, and 95,500 bonds outstanding, par value $1,000 each. The common share currently sells for $40 per share and has a beta of 1.5, the preferred stock currently sells for $190 per share with a preferred dividend to be paid forever of $9.50, and the bonds sell for 110 percent of par. The expected market risk premium is 6%, the interest rate on newly issued debt, with the same risk as Ellay’s bonds, is 5% and the company's tax rate is 35%.  

Ellay steel Corporation is intending to implement a stable dividend policy on its common shares where 30% represent its payout ratio. Moreover, this corporation aims at evaluating two projects using its WACC estimated to 7.5%.   

1. What is the total market value of the firm?

2. Calculate capital structure weights.

3. What is the company’s after-tax cost of debt (R_D)?

4. Determine the cost of preferred stock R_P then compute the cost of equity R_E and prove that R_E = 13.66%. (You will need this result to answer the following questions: e. and f.)

5. If the ROE is equal to 12% and no external capital would be newly raised, what are the capital gain yield and the dividend yield of common shares? What would be the initial dividend to be paid (D₀) on these common shares?

6. Compute the risk-free rate (R_f) using the SML approach.

2. Ellay steel corp. is evaluating two different steel bending machines using its WACC of 7.5%. Machine A costs $320,000, has a three-year life, and has pre-tax operating costs of $83,000 per year. Machine B costs $495,000, has a five-year life, and has pre-tax operating costs of $42,000 per year. Both bending machines are in Class 8 (CCA rate of 20% per year). Recall that Ellay’s tax rate is 35%.

1. Assume that there is no salvage value for both machines and compute the EAC for each one.

2. Which one would be chosen by Ellay corp? Why?

Answer 1

1) Statement showing market value of firm

Source of capital	No of units	Market price per unit	Total market price
	A	B	C = A x B
Common stock	1900000	40	76000000
Preference stock	50000	190	9500000
Bonds	95500	1100	105050000
Market value of firm	190550000

Thus market value of firm = $ 190,550,000

2) Statement showing capital structure weights

Source of capital	Total market price	Weight	Calculation
Common stock	76000000	40%	76000000/190550000
Preference stock	9500000	5%	9500000/190550000
Bonds	105050000	55%	105050000/190550000
	190550000

3) After tax cost of debt = YTM of new bond(1-tax rate)

=5%(1-0.35)

=5%(0.65)

=3.25%

4) Cost of preference share = Dividend / Price of preference share

= 9.5/190

=0.05

i.e 5%

now we are given with WACC = 7.5%

WACC = (Weight of equity x cost of equity) + (Weight of debt x cost of debt) + (Weight of prefernce share x cost of preference shares)

=7.5% = 0.4 x Cost of equity + (55% x 3.25%) + (5% x 5%)

=7.5% = 0.4 x Cost of equity + 1.7875% + 0.2500%

Thus 0.4 x Cost of equity = 7.5% - 1.7875% - 0.2500%

0.4 x Cost of equity = 5.4625%

Cost of equity = 13.66%

Thus proved.