Question

You are attending an interview session for a post of finance officer at Ukay Budiman Corporation (UBC). During the interview, the director of UBC have raised his concern on how to set an appropriate benchmark to evaluate the company’s investment. As for now, UBC needs to purchase a new office building to support its business expansion. Therefore, a certain amount of capital is needed to finance its purchase. The company is planning to finance through bond and stock issues. For bond, UBC plans to issue a 15-year bond with an 8 percent annual coupon, and RM1,000 par value at a price of RM990 per unit. However, the flotation cost per bond issuance is 5 percent of its par value. The whole issuance of bond will amount to total par value of RM12,000,000. For stock issue, UBC plans to issue 1,500,000 additional shares. UBC stock is currently selling for RM11 per share with a flotation cost of RM2.20 per share. An investment consultant has indicated that the UBC’s beta is estimated to be 1.25. At current economic condition, the risk-free rate is equal to 6.5% and the average market return is 13 percent. The corporate tax rate is 25 percent.

Based on the current scenario, you are required to calculate:

a) The total amount of financing that UBC plans to get.

b) The proportion of debt and equity in UBC’s target capital structure.

c) The after-tax cost of debt

d) The cost of newly issues common stock

e) UBC’s weighted average cost of capital (WACC)

 

Answer 1

a.

The amount of financing the UBC plans to get is the amount raised after floatation costs.

Let us calculate the number of bonds issued = total par value/par value of 1 bond
                                                                                = 12,000,000/1,000
                                                                                = 12,000 bonds

 

The amount received from these bonds = (market value per bond – floatation cost) x number of bonds
                                                                        = (990 – 50) x12,000
                                                                        = 940 x 12,000
                                                                       = 11,280,000

 

where floatation costs = 5% of par value = 5% x 1000 = RM50

 

Amount raised from equity = (market price – floatation costs) x number of shares issued
                                                 = (11 – 2.20) x1,500,000
                                                 = 8.8 x 1,500,000
                                                 = RM 13,200,000

 

Total financing = amount raised from debt + amount raised from equity = 11,280,000 + 13,200,000
                                                                                                                                 = 24,480,000

 

The amount of financing UBC plans to get is RM 24,480,000

 

b.

Total capital raised = 24,480,000
Proportion of each capital can be calculated with the formula below:
amount in each source of capital/total capital raised.

Weight of debt (Wd) = 11,280,000/24,480,000 = 0.46078431 = 0.46
Weight of equity (We) = 13,200,000/24,480,000 = 0.539216 = 0.54

 

Proportion of debt is 46% and proportion of equity is 54%

 

c.

Cost of debt can be calculated as YTM. The formula to calculate YTM is as below:

 

= 80 + 1000 – 940/15 / 1000 + 940/2 

= 84/970

= 0.086598
= 8.6598%

Where coupon = 8% of par value = 8% x 1000 = 80
FV = Face value/par value = 1000
PV = price of the bond = price – floatation cost = 990 – 50 = 940
n = years to maturity = 15

Cost of debt is 8.66% (rounded to 2 decimal points)

 

After tax cost of debt = Cost of debt x (1 – tax rate)
                                       = 8.66% x (1 – 0.25)
                                       = 8.66% x 0.75
                                       = 6.495%

 

After tax cost of debt is 6.495%

 

d.

Cost of equity can be determined with a CAPM formula where
Cost of equity = riskfree rate + beta (market return – riskfree rate)
                          = 6.5% + 1.25 (13 – 6.5)
                         = 6.5 + 1.25 x 6.5
                         = 14.625%

 

Cost of equity is 14.625%.

 

e.

WACC is calculated with the formula below:

WACC = Wd x after tax cost of debt + We x cost of equity
            = 0.46 x 6.495% + 0.54 x 14.625%
           = 2.9877% + 7.8975%
           = 10.8852%

 

UBC’s WACC is 10.8852%.

a. The amount of financing UBC plans to get is RM 24,480,000

b. Proportion of debt is 46% and proportion of equity is 54%