Question

Ruskin has the following balance sheet:

Current assets $30,000,000, Current liabilities $10,000,000, Fixed assets 60,000,000, Long-term debt 25,000,000, Common stock (1 million shares) 1,000,000, Retained earnings 39,000,000, Preferred Stock 15,000,000, Total assets $90,000,000, Total claims $90,000,000.

The current liabilities consist entirely of notes payable to banks, and the interest rate on this debt is 10%, the same as the rate on new bank loans. These bank loans are not used for seasonal financing but instead are part of the company’s permanent capital structure. The long-term debt consists of 30,000 bonds, each with a par value of $1,000, an annual coupon interest rate of 6%, and a 20-year maturity. The going rate of interest on new long-term debt, rd., is 12%.The Preferred stock market value remains unchanged. The common stock currently sells at a price of $70 per share. The Market value of bonds is 40m. . Required rate of return of common stockholders is 13% and preferred stockholders is 7%. Calculate the firm’s book value and market value capital structure. Also find Wacc using book value weights and market value weights.

Note: Please solve using a financial calculator. Do it manually. Show workings. Do not use Excel!

Answer 1

firm's book value capital structure

total book value of capital structure = book value of (notes payable + Long-term debt + Preferred stock + Common stock)

total book value of capital structure = $10,000,000 + $25,000,000 + $15,000,000 + $1,000,000 = $51,000,000

book value weight of notes payable = book value of notes payable/total book value of capital structure = $10,000,000/$51,000,000 = 0.20

book value weight of long-term debt = book value of long-term debt/total book value of capital structure = $25,000,000/$51,000,000 = 0.49

book value weight of Preferred stock = book value of Preferred stock/total book value of capital structure = $15,000,000/$51,000,000 = 0.29

book value weight of Common stock = book value of Common stock/total book value of capital structure = $1,000,000/$51,000,000 = 0.02

firm's market value capital structure

total market value of capital structure = market value of (notes payable + Long-term debt + Preferred stock + Common stock)

market value of Common stock = no. of shares outstanding*current price per share = 1,000,000*$70 = $70,000,000

market value of notes payable and preferred stock are same as book value.

total market value of capital structure = $10,000,000 + $40,000,000 + $15,000,000 + $70,000,000 = $135,000,000

market value weight of notes payable = market value of notes payable/total market value of capital structure = $10,000,000/$135,000,000 = 0.07

market value weight of long-term debt = market value of long-term debt/total market value of capital structure = $40,000,000/$135,000,000 = 0.30

market value weight of Preferred stock = market value of Preferred stock/total market value of capital structure = $15,000,000/$135,000,000 = 0.11

market value weight of Common stock = market value of Common stock/total market value of capital structure = $70,000,000/$135,000,000 = 0.52

WACC = weight of notes payable*cost of notes payable + weight of long-term debt*cost of long-term debt + weight of preferred stock*cost of preferred stock + weight of common stock*cost of common stock

cost of notes payable and long-term debt have after-tax cost due to interest on them is tax deductible and reduces cost of these two. no tax rate is given in the question. so, it is assumed cost of notes payable and long-term debt are after-tax.

cost of new notes payable is 10%. cost of new long-term debt is 12% and cost of preferred and common stock are 7% and 13%.

WACC using book value weights

WACC = 0.20*10% + 0.49*12% + 0.29*7% + 0.02*13% = 2% + 5.88% + 2.03% + 0.26% = 10.17%

WACC using market value weights

WACC = 0.07*10% + 0.30*12% + 0.11*7% + 0.52*13% = 0.7% + 3.6% + 0.77% + 6.76% = 11.83%