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Question 3 DYB Battery is a battery manufacturer producing high-quality lithium ion battery cells or electric...

Question 3

DYB Battery is a battery manufacturer producing high-quality lithium ion battery cells or electric cars. The business of DYB has been flourishing in recent years and the board of directors intends to expand the business by acquiring companies overseas. One of the acquisition targets is an electric car manufacturer in Taiwan. The management of DYB believes this car manufacturer will bring handsome revenue to the company in the future. As a business analyst of the DYB, you have been asked to determine the Weighted Average Cost of Capital (WACC) of your company. The senior management of the company would like to use DYB’s WACC to benchmark potential acquisition targets.The current capital structure information of the company is as follows: i 800,000 shares of common stock with a currently price of $50 per share ii 500,000 shares of preferred stock currently trading at $40 per share in the market. The fixed annual dividend of this preferred stock is $4.80 per share. iii 30,000 units of 10-years, 7% p.a. coupon bonds with semi-annual interest payment. The bond has exactly four years to maturity with a par value of $1,000. The current quotation of this bond is 95, which means 95% of its par value. Bonds with similar risk, interest term and maturity are currently selling at 8.50067% p.a. yield to maturity. iv An $11,500,000 long-term bullet payment loan with Open Bank. The loan was borrowed two months ago with a 9% p.a. borrowing rate. The market value of this bank loan is not available. v The expected market return is 12%, the risk-free rate is 4% and the beta of DYB’s common stock is 1.25 respectively. The marginal tax rate is 20%. Answer the following questions:

a What is the capital structure of DYB on a market value basis? Please make assumptions in your calculation if necessary.

b Evaluate the weighted average cost of capital (WACC) of the company.

c Discuss whether DYB should simply apply its WACC as the benchmark to evaluate the acquisition of the electric car manufacturer.

Solutions

Expert Solution

capital structure of DYB on a market value basis

Question 1

Particulars

Units

market price

Market value

Equity

800,000

50

40000000

preferred stock

500,000

40

20000000

7% coupon bonds

30,000

950

28500000

long-term

11,500,000

100000000

Question 2

Computation of WACC

cost of equity as CAPM

Formula Ke= Rf+?(Rm-Rf)

Rf

4%

Rm

12%

?

1.25

Ke( cost of equity)

14.00%

We assumed YTM is after tax .

Ytm( bond)

8.50067%

Kd= i( 1-tax)( debt)

7.20%

Kp( 4.80/40)=( perefered stock)

12.00%

Particulars

Market value

weights  

cost of capital

WACC

Equity

40000000

0.4

14%

0.056

preferred stock

20000000

0.2

12%

0.024

7% coupon bonds

28500000

0.285

8.50%

0.02422691

long-term

11500000

0.115

7.20%

0.00828

100000000

11.25%

WACC

11.25%

Question 3

DYB will Apply its WACC as the benchmark to evaluate the acquisition of the electric car manufacturer.

WACC is the blended required rate of return by investors of all types (senior debt, junior debt, equity etc.)

The balance sheet says that Assets = Liabilities, or uses = sources

Thus we assume that the required return on the assets of the company as they have been organized is equal to the one required by the people financing it. (it would otherwise be difficult to estimate that required return on assets)

The discount rate used in a DCF is meant to represent the rate of returns required by investors to invest in the set of assets GENERATING these cash flows. hence the use of the wacc.

WACC is typically market driven because the capital structure used in its calculation comes from current market prices. That means it will help you determine at what rate the company will be able to borrow.


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