Question

Blooming Ltd. currently has the following capital structure: Debt: $2,500,000 par value of outstanding bond that pays annually 12% coupon rate with an annual before-tax yield to maturity of 10%. The bond issue has face value of $1,000 and will mature in 25 years. Ordinary shares: 65,000 outstanding ordinary shares. The firm plans to pay a $7.50 dividend per share in the next financial year. The firm is maintaining 3% annual growth rate in dividend, which is expected to continue indefinitely. Preferred shares: 40 000 outstanding preferred shares with face value of $100, paying fixed dividend rate of 14%. Company tax rate is 30%. Required: Complete the following tasks: a) Calculate the current price of the corporate bond? b) Calculate the current price of the ordinary share if the average return of the shares in the same industry is 9%? c) Calculate the current value of the preferred share if the average return of the shares in the same industry is 12% d) Calculate the current market value (rounded off to the nearest whole number) and capital structure of the firm (rounded off to two decimal places). Identify the total weights of equity funding e) Compute the weighted average cost of capital (WACC) under the traditional tax system for the firm, using dividend constant growth model for calculation the cost of ordinary equity

Answer 1

a) No. of Bonds of Face value $1000 = $2500000 / $1000 = 2500

Coupon amount per Bond of Face value $1000 = $1000*12% = $120

Current price of Corporate bond = 120/0.1*(1-1/1.1^25)+1000/1.1^25 = $1181.54

b) From Gordon's constant growth model

Price of one share = Dividend next year/ (required rate of return - constant growth rate)

= $7.5/(0.09-0.03) =$125

c) Current value of preferred share = Annual Preference Dividend/ Required rate of return

= ($100*14%) / 0.12 = $116.67

d) Total market Value of Debt = $1181.54* 2500 = $2,953,852

Total market value of Equity = $125* 65000 = $8,125,000

Total Market value of Preference Shares =$116.67*40000 =$4,666,666.67

Current market value of firm = $2953852+$8125000+$4666666.67 = $15745519 (rounded to nearest whole number)

Proportion of Debt in the firm = 2953852/15745519 = 18.76%

Proportion of Equity in the firm = 8125000/15745519 = 51.60%

Proportion of preference shares in the firm = 4666666.67/15745519 = 29.64%

which is the required capital structure of the firm

e) pretax cost of debt = YTM =10%

Cost of equity = next year dividend/Share price+ constant growth rate

=7.5/125+0.03

=0.09 or 9%

Cost of preference shares = 12%

So, WACC = proportion of debt*cost of debt*(1-tax rate) + proportion of equity*cost of equity+proportion of preference shares*cost of preference shares

=0.1876*10%*(1-0.3) +0.5160*9%+0.2964*12%

=9.51394%