Question

WACC Estimation

The following table gives the balance sheet for Travellers Inn Inc. (TII), a company that was formed by merging a number of regional motel chains.

Travellers Inn: (Millions of Dollars)
Cash		$  10		Accounts payable		$  10
Accounts receivable		20		Accruals		15
Inventories		20		Short-term debt		0
Current assets		$  50		Current liabilities		$  25
Net fixed assets		50		Long-term debt		30
				Preferred stock (50,000 shares)		5
				Common equity
				Common stock (3,800,000 shares)		$  10
				Retained earnings		30
				Total common equity		$  40
Total assets		$100		Total liabilities and equity		$100

The following facts also apply to TII:

1. The long-term debt consists of 29,412 bonds, each having a 20-year maturity, semiannual payments, a coupon rate of 7.4%, and a face value of $1,000. Currently, these bonds provide investors with a yield to maturity of 11.8%. If new bonds were sold, they would have an 11.8% yield to maturity.
2. TII's perpetual preferred stock has a $100 par value, pays a quarterly dividend per share of $3, and has a yield to investors of 10%. New perpetual preferred stock would have to provide the same yield to investors, and the company would incur a 3.25% flotation cost to sell it.
3. The company has 3.8 million shares of common stock outstanding, a price per share = P₀ = $20, dividend per share = D₀ = $1, and earnings per share = EPS₀ = $5. The return on equity (ROE) is expected to be 10%.
4. The stock has a beta of 1.6. The T-bond rate is 7%, and RP_M is estimated to be 5%.
5. TII's financial vice president recently polled some pension fund investment managers who hold TII's securities regarding what minimum rate of return on TII's common would make them willing to buy the common rather than TII bonds, given that the bonds yielded 11.8%. The responses suggested a risk premium over TII bonds of 2 percentage points.
6. TII is in the 25% federal-plus-state tax bracket.

Assume that you were recently hired by TII as a financial analyst and that your boss, the treasurer, has asked you to estimate the company's WACC under the assumption that no new equity will be issued. Your cost of capital should be appropriate for use in evaluating projects that are in the same risk class as the assets TII now operates. Based on your analysis, answer the following questions. Do not round intermediate calculations. Round your answers to two decimal places.

1. What are the current market value weights for debt, preferred stock, and common stock? (Hint: Do your work in dollars, not millions of dollars.)

   	Weight
   Debt	%
   Preferred stock	%
   Common stock	%

2. What is the after-tax cost of debt?

     %

3. What is the cost of preferred stock?

     %

4. What is the required return on common stock using CAPM?

     %

5. Use the retention growth equation to estimate the expected growth rate. Then use the expected growth rate and the dividend growth model to estimate the required return on common stock.

     %

6. What is the required return on common stock using the own-bond-yield-plus-judgmental-risk-premium approach?

     %

7. What is Travellers' WACC? Use the required returns on stock from part e.

     %

Answer 1

First Compute WACC		a)	b),  c) & e)	g)
	Market Value	Weights	Cost	WACC
Debt	$19,552,091.94	19.25%	8.85%	1.70%
Common Stock	$76,000,000.00	74.84%	5.10%	3.82%
Preferred Stock	$6,000,000.00	5.91%	3.10%	0.18%
Total	$101,552,091.94	100.00%		5.70%
WACC	10.39%
Debt
Face Value	$1,000.00
Coupon Payment = 1000 x 7.4%/2	$37.00
Nper = 20 x 2	40
Semi Annual Cost of Debt = YTM = Rate = 11.8%/2	5.90%
Present Value = $1000 x 94.5%	$664.77
Market Value = 29412 x  664.77	$19,552,091.94
After tax of debt = 11.8% x (1-25%)	8.85%	(b)
Common Stock
Cost of Equity = Risk free rate + Beta x Market Risk Premium = 7% + 1.6 x 5%	15.00%	(d)
Market Value = 3,800,0000  shares x $20	$76,000,000.00
Preferred Stock
Value of Preferred = Dividend /Yield = $3/(10% /4)	$                                   120.00
Market Value = 50,000 shares x 120	$6,000,000.00
Cost of preferred =$3/$100 x (1 - 3.25%) =	3.10%	( c)
e)
Growth rate = 10% x $1/$5	2.00%
Required Return = ($1 x (1+2%))/$20	5.10%
f)
Return on common stoc k = 11.8% + 2%	13.800%