Question

You are provided the following information:

Capital Structure:

Debt                                         $    60000

Equity                                       $   180000

The firm sold 50 year; $ 1000 face value, 5% bonds 10 years ago. These bonds trade at $ 930. You expect the yield on these bonds to be a good proxy for the cost of issuing new bonds.

The shares trade at $ 20; the growth rate is 6%. Dividends paid last year - $ 1.00.

The firm has a 30% tax rate.

Kemper, Goebel & Benkato, Investment Bankers have informed you that new shares can be sold with a 10% transaction cost.

New 50 year bonds can be sold. The firm can collect:

$ 0          --             $      120000            6%

The firm added $ 180000 to retained earnings last year.

As the intern, compute the cost of capital {WACC} for the CFO.

a) Compute the yield till maturity on the old bonds. So, what is the proxy for the sale of new bonds?

b) What return do the shareholders expect?

c)What are the weights of debt and equity in the capital structure of the firm?

d) Compute the WACC.

e) WHY do you compute the WACC?

f) How much can you borrow with the amount you have added to retained earnings last year? Note: NO change in capital structure.

g) Compute the WACC IF your CFO wants a ‘NEW’ capital structure with 60% debt. [use old costs]

h) What is the cost of equity when new shares are sold?

i. Compute the WACC if you borrow over $ 60001 with the ‘OLD’ capital structure.

The firm has the following projects:

I                              IRR

1.      30,000                     8%

2.     70,000                     11%

3.     50,000                     10%

4.     25,000                     7%

Help the CFO make a decision.

Answer 1

a.

Original maturity of bond is 50% and 10 year already passed, so number of year remains in maturity is 40 year.

Yield to maturity is calculated in excel and screen shot provided below:

Yield to maturity of bond is 5.43%.

Before tax cost of debt = 5.43%

Tax rate = 30%

after tax cost of debt = 5.43% × (1 - 30%)

= 3.80%

after tax cost of debt is 3.80%.

b.

Expected return on equity = [Last dividend × (1 + growth rate) / Current stock price] + growth rate

= [$1 × (1 + 6%) / $20] + 6%

= 5.30% + 6%

= 11.30%

Expected return on equity is 11.30%.

c.

Value of debt = $60,000

Value of equity = $180,000

Value of total capital = $60,000 + $180,000

= $240,000

Value of total capital is $240,000.

Weight of debt = $60,000 / $240,000

= 25%

Weight of equity = 75%

Weight of debt is 25% and weight of equity is 75%.

d.

WACC = (75% × 11.30%) + (25% × 3.80%)

= 8.48% + 0.95%

= 9.43%

WACC of company is 9.43%.