Question

Beltway Technologies: Balance Sheet for the Year Ended December 31, 2017 (in Millions of Dollars)
Cash Accounts receivable Inventory      Current assets Net fixed assets Total assets	$    5.1 26.4     56.1 $ 87.6     26.3 $113.9	Accounts payable Accruals Notes payable     Current liabilities Long-term debt Preferred stock Common stock Total claims	$   3.8 5.9      1.3 $10.1 40.8 9.7    53.3 $113.9

To begin, Bill reviewed Beltway's 2017 balance sheet, which is contained in Table 1. Next, Bill assembled the following relevant data:

(1)    The firm's tax rate is 25 percent.

(2)    Beltway's 8.0 percent semiannual coupon bonds with 15 years remaining to maturity are not actively traded. However, a block did trade last week at a price of $980 per bond.

(3)    Beltway uses short-term debt only to fund cyclical working capital needs.

(4)    The firm's pays a $2.50 quarterly dividend ($10.00 per year) on perpetual preferred stock (par value of $100) that is traded on the American Stock Exchange AMEX. Its current price is $102 per share; however, Beltway would incur flotation costs of $1.00 per share on a new issue.

(5)    Beltway's common stock is currently selling on the AMEX at $45 per share. The firm's last year’s dividend D₀ was $2.00, and dividends are expected to grow at roughly a 8 percent annual rate in the foreseeable future.

(6)    The firm's historical beta, as measured by a stock analyst who follows the firm, is 1.3. The current yield on long-term T-bonds is 5.0 percent, and a prominent investment banking firm has recently estimated the market return is 10%.

(7)    The required rate of return on an average (A-rated) company's long-term debt is 7.0 percent.

(8)    The firm's market value target capital structure is 30 percent debt, 10 percent preferred stock, and 60 percent common stock.

. With these data at hand, consider the following questions which Bill must address in his analysis.

Questions

1.      What sources of capital should be included in Beltway's cost of capital estimate? Should the component cost estimates be before tax or after tax?

2.      Consider Beltway's cost of debt.

a.   What is the cost estimate for this component?

.

3.      Now consider the firm's cost of preferred stock.

a. What is the preferred cost estimate?

4.      Now consider the cost of common equity.

a. Why is there a cost associated with retained earnings?

b.   What is Beltway's estimated cost of retained earnings using the CAPM approach?

5.     What is the discounted cash flow (DCF) cost of retained earnings estimate?

6.      What is the bond-yield-plus-risk-premium estimate for Beltway's cost of retained earnings.

7.      What is your final estimate for r_s? Explain how you weighed the estimates of the three methods.

8.         What is the WACC?

Answer 1

Part 1:- Beltway's can use different sources of capital like equity share capital, preference share capital, debentures, loan or a combination of all of these in different proportions.

Component coaf of capital should be calculated after tax to take tax benefits into account while assessing the real cost of the source of capital. Because in case of debt financing companies bear less cost due to the tax shield.

Part 2:-

Current market price = present value of coupon payments and redemption value of bond on maturity

Here,

Semiannual interest is 8 %

This makes annual interest equal to 8.16% calculated using (1+0.08/2)^2= 1+i

This gives i=8.16%

Now,

Let cost of debt is 'i'

980= 81.6/(1+i)+81.6/(1+i)^2+....+81.6/(1+i)^15+1000/(1+i)^15

Now, 980= 81.6*PVAF@ _{i, 15} +1000*PVF_{@ i, 15}

Now calculating the above equation at

i=10% gives 860.0477

i= 5% gives 1328.00352

Now using interpolation

(1328-980)/(1328-860.0477)=(0.05-i)/(0.05-0.10)

i= 8.7183%

Part3:- current market price = dividend paid annually for perpetuity / cost of preferred stock

This implies

102= 10/i

i= 9.8039%

Note: According to me floatation cost should not be taken into consideration because it is not mentioned in the question that the company made any new issue.

Part4:- Retained earnings are the profits that the company holds with itself rather than distributing them as dividends to its shareholders. This leads to creation of some obligations on the company to use the shareholders money wisely in oeder to give them high returns. That is why there is cost associated with retained earnings.

Beltway's estimated costs of retained earnings using CAPM = risk free rate of return + beta * risk premium

= 0.05+ 1.3* (0.10-0.05)

=11.5%

Part5:- Price= D₁/(i-g)

Here, i= cost of equity

g= growth rate of dividend

Here, D₁ = D₀ (1+g)

= 2* 1.08= 2.16

45= 2.16/(i- 0.08)

i= 12.8%

Part6 :- cost of retained earnings = 0.05+ 1.3*(0.10-0.05)

=11.5%

Part7:- According to me, cost of retained earnings calculated using Discounted cash flow method are the best estimate because it gives the intrinsic value of the share which is based on long term where as CAPM considers that the investor should be paid only for bearing systematic risk(i.e.the risk which cannot be diversified).

Part8 :- WACC= proportion of debt in capital structure* cost of debt+ proportion of preferred stock * cost of preferred stock + proportion of equity in capital structure* cost of equity

= 0.30*0.087183+0.10*0.098039+0.60*.128

=11.275%