Question

a) Equity can form part of a company’s capital structure. What would an investor consider the optimal mix?
b) PaZed Corporation is expected to have a temporary supernormal growth period and then level off to a “normal,” sustainable growth rate forever. The supernormal growth is expected to be 25% for 3 years and then level off to 8% forever. The market requires a 14% return on investment and the company last paid a K 1.60 dividend. What would the market be willing to pay for the stock today?
c) Bushel Recycling Ltd. is a well-established recycling business. The company has the following capital structure: Debt 20%; Preferred stock 15% and Equity 65% .The market attracts interest rates of 15% for debt and 13% for preferred stock, with a corporate tax rate of 35%. The market beta for metal scrap companies is 1.5, while the risk free rate is 12%.The market risk premium is 5%.
Required
Using the CAPM approach, determine the appropriate WACC.
d) ABZ milling company balance sheet shows the following capital structure for 2010
9% Debt K4, 500,000
7% preferred Stock K1, 500,000
Common Stock K1, 000,000
The company last dividend was K4 and is expected to grow at 5 percent yearly and common stock is currently quoted at K40.The corporate tax rate is 33%.
Calculate the weighted average cost of capital (WACC) for Timber limited.

Answer 1

a. An optimal mix ,as per the investor ,is the ideal debt-to-equity ratio that maximises shareholder wealth & minimises the weighted average cost of capital.
b.. Future cash flows from the stock
Year		Dividend	PV F at 14%	PV at 14%
0	1.6
1	1.6*1.25^1=	2	0.87719	1.754386
2	1.6*1.25^2=	2.5	0.76947	1.923669
3	1.6*1.25^3=	3.125	0.67497	2.109286
3	(3.125*1.08)/(0.14-0.08)=	56.25	0.67497	37.96715
	(Terminal value)
	Stock price today			43.75449
			ie.	43.75
				(Answer)

c.. As per CAPM,

Cost of Equity=RFR+(Beta*Market Risk Premium)

Cost of Equity=12%+(1.5*5%)= 19.5%

After-tax cost of debt= 15%*(1-35%)=

9.75%

Cost of preferred stock= 13%

WACC=(Wd*Kd)+(Wp*Kp)+(We*Ke)

So, WACC=(20%*9.75%)+(15%*13%)+(65%*19.5%)=

16.58%

d.

After-tax cost of debt=9%*(1-33%)=

6.03%

Cost of preferred stock= 7%

Cost of Equity ----as per dividend discount model---

Ke=( Next dividend/Current stock price)+growth rate

ie. Ke=((4*1.05)/40)+0.05=

15.5%

WACC=(Wd*Kd)+(Wp*Kp)+(We*Ke)

ie. WACC= (4500000/7000000*6.03%)+(1500000/7000000*7%)+(1000000/7000000*15.5%)=

7.59%