Question

Use the following information to answers questions 17 to 26.  (Long Answer/Essay – primarily Chapter 13 but includes concepts from many chapters) You are the CFO of Micro Spinoff Inc. The company has 3,000,000 shares of common stock outstanding at a market price of $50 a share. Micro Spinoff just paid an annual dividend in the amount of $3.12 per share. The dividend growth rate is 5.8 percent annually. Micro Spinoff also has 70,000 bonds outstanding with a face value of $1,000 per bond that are selling at 115.372 percent of par. The bonds have a 12 percent coupon, pay interest semi-annually, and have 15 years to maturity. Finally, the firm has 400,000 shares of preferred stock outstanding at a market price of $58.48 a share. Preferred stocks pay dividend of 6.67 percent on its par value of $75.00.

The firm is considering a three-year expansion project (same operations as the existing projects of the firm) that requires an initial investment in a machine of $200,000. The increase in Net Working Capital (NWC) at time 0 is $10,000 that will be reduced to normal levels at the end of the project at time 3. The machine has a life of 4 years and will be depreciated to 0 using straight-line method. The Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) in the first year is $70,000 and this will grow at 6 percent a year. At the end of the project (year 3), the machine can be sold for $10,000. The firm’s tax rate is 21 percent.

1. what is the firms weighted average cost of capital

Answer 1

Common equity:

D1 = D0 x (1 + g) = 3.12 x (1 + 5.8%) = $ 3.30

Cost of equity, Ke = D1/P + g = 3.30 / 50 + 5.8% = 12.40%

Market value of equity, E = N x P = 3,000,000 x 50 = 150,000,000

Bonds:

PV = -115.372% = -115.372 x 1,000 = -1153.72; n = 2 x 15 = 30; PMT = semi annual coupon = 12%/2 x 1,000 = 60

Hence, pre tax cost of debt = Kd = YTM = 2 x RATE (Nper, PMT, PV, FV) = 2 x RATE (30, 60, -1153.72, 1000) = 10.00%

Market value of bonds = D = N x PV = 70,000 x 1153.72 = $   80,760,400

Preferred stock:

the firm has 400,000 shares of preferred stock outstanding at a market price of $58.48 a share.

Dividend, D = 6.67% x par value of $75.00 = 5.0025

Cost of preferred stock, Ks = D / P = 5.0025 / 58.48 = 8.55%

Market value of preferred stock, S = N x P = 400,000 x 58.48 = $  23,392,000

Total capital, C = E + D + S =  150,000,000 + 80,760,400 + 23,392,000 =  254,152,400

Proportion of debt = Wd = D / C = 80,760,400 /   254,152,400 = 31.78%

Proportion of preferred stock = Ws = S / C =  23,392,000 / 254,152,400 = 9.20%

Proportion of common equity = We = E / C = 150,000,000 / 254,152,400 = 59.02%

Tax rate = T = 21%

Hence, WACC = Wd x Kd x (1 - T) + Ws x Ks + We x Ke = 31.78% x 10.00% x (1 - 21%) + 9.20% x 8.55% + 59.02% x 12.40% = 10.62%