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In: Accounting

Happy Guys (HG) is a toy production company. The business of HG has been declining in...

Happy Guys (HG) is a toy production company. The business of HG has been declining in recent years and the board of directors wants to increase the company’s revenue by expanding its product mix. One of the candidate projects is to buy a high-tech production line and build precision robots for manufacturers. The management believes this product line can bring a huge profit to the company in future.

As a business analyst in HG, you have been asked to evaluate whether the robot manufacturing project will be a good investment for the company. Before evaluating the new project, your boss asks you to identify the weighted average cost of capital (WACC) of HG itself. The following is some information about the capital structure of HG:
i. 10,000 units of eight-year coupon bonds with 11.70% p.a. semi-annual interest payment — this bond has exactly four years to maturity with a par value of $1,000. The current quotation
for this bond is $120, which means the market price is 120% of its par value. Bonds with a similar risk, interest term and maturity are currently selling at 6% p.a. yield to maturity.
ii. A $11,000,000 long-term bullet payment loan with Open Bank — the loan was borrowed three months ago with a 5.15% p.a. borrowing rate. The market value of this bank loan is not
available.
iii. 5,000,000 shares of common stock with a par value of $1,currently trading at $3 per share.
iv. 300,000 shares of 9% preferred stock with a par value of $50, currently trading at $40 per share in the market.
v. The expected market return (E(RM)) is 10%, the risk-free rate (Rf) is 3%, and the beta of HG’s common stock is 1.6. The marginal tax rate is 25%.

Answer the following questions.
a. Assess the capital structure of Happy Guys on a market value basis. If necessary, please make assumption(s) in your calculation.
b. Evaluate the weighted average cost of capital (WACC) of Happy Guys.
c. Suppose Happy Guys is to use its WACC as the benchmark to evaluate its projects regardless of project risk. If the market is efficient, what two potential mistakes may the firm make? Use
a graph to illustrate your answer, followed by an explanation.

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ekkarill92 answered 2 years ago
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