Question

WACC Estimation

The following table gives the balance sheet for Travellers Inn Inc. (TII), a company that was formed by merging a number of regional motel chains.

Travellers Inn: (Millions of Dollars)
Cash		$10		Accounts payable		$10
Accounts receivable		20		Accruals		10
Inventories		20		Short-term debt		5
Current assets		$50		Current liabilities		$25
Net fixed assets		50		Long-term debt		30
				Preferred stock		5
				Common equity
				Common stock		$10
				Retained earnings		30
				Total common equity		$40
Total assets		$100		Total liabilities and equity		$100

The following facts also apply to TII:

1. Short-term debt consists of bank loans that currently cost 11%, with interest payable quarterly. These loans are used to finance receivables and inventories on a seasonal basis, so bank loans are zero in the off-season.
2. The long-term debt consists of 20-year, semiannual payment mortgage bonds with a coupon rate of 8%. Currently, these bonds provide a yield to investors of r_d = 12%. If new bonds were sold, they would have a 12% yield to maturity.
3. TII's perpetual preferred stock has a $100 par value, pays a quarterly dividend of $2.50, and has a yield to investors of 10%. New perpetual preferred stock would have to provide the same yield to investors, and the company would incur a 5% flotation cost to sell it.
4. The company has 4 million shares of common stock outstanding. P₀ = $20, but the stock has recently traded in the price range from $17 to $23. D₀ = $1 and EPS₀ = $2. ROE based on average equity was 24% in the most recent year, but management expects to increase this return on equity to 32%; however, security analysts and investors generally are not aware of management's optimism in this regard.
5. Betas, as reported by security analysts, range from 1.3 to 1.7; the T-bond rate is 9%; and RP_M is estimated by various brokerage houses to range from 4.5% to 5.5%. Some brokerage house analysts report forecasted dividend growth rates in the range of 10% to 15% over the foreseeable future.
6. TII's financial vice president recently polled some pension fund investment managers who hold TII's securities regarding what minimum rate of return on TII's common would make them willing to buy the common rather than TII bonds, given that the bonds yielded 12%. The responses suggested a risk premium over TII bonds of 4 to 6 percentage points.
7. TII is in the 35% federal-plus-state tax bracket.
8. TII's principal investment banker predicts a decline in interest rates, with r_d falling to 10% and the T-bond rate to 6%, although the bank acknowledges that an increase in the expected inflation rate could lead to an increase rather than a decrease in interest rates.

Assume that you were recently hired by TII as a financial analyst and that your boss, the treasurer, has asked you to estimate the company's WACC under the assumption that no new equity will be issued. Your cost of capital should be appropriate for use in evaluating projects that are in the same risk class as the assets TII now operates.

1. What are the market value weights for long-term debt, preferred stock, and common stock in Travellers' capital structure? Do not round intermediate calculations. Round your answers to two decimal places.

   	Weight
   Long-term debt	%
   Preferred stock	%
   Common stock	%

2. What is the required return on long-term debt? Round your answer to two decimal places.

     %

3. What is the required return on preferred stock? Do not round intermediate calculations. Round your answer to two decimal places.

     %

4. Using the DCF model and the retention growth model for g, what is the required return on stock? Do not round intermediate calculations. Round your answers to two decimal places.

   Estimate of g	Retention growth model	Lowest analyst g	Highest analyst g
   Required return on stock	%	%	%

5. Using the own-bond-yield-plus-judgemental-risk-premium approach, what is the required return on stock? Do not round intermediate calculations. Round your answers to two decimal places.

   Required return on stock (judgemental risk premium = 4%):   %

   Required return on stock (judgemental risk premium = 6%):   %

6. Using the CAPM approach, what is the required return on stock? Do not round intermediate calculations. Round your answers to two decimal places.

   Required return on stock (beta = 1.3, RP_M = 4.5%):   %

   Required return on stock (beta = 1.3, RP_M = 5.5%):   %

   Required return on stock (beta = 1.7, RP_M = 4.5%):   %

   Required return on stock (beta = 1.7, RP_M = 5.5%):   %

7. What is Travellers' WACC? Use the required returns on stock from part e. Do not round intermediate calculations. Round your answers to two decimal places.

   WACC (lowest required return on stock):   %

   WACC (highest required return on stock):   %

Answer 1