Question

Blooming Ltd. currently has the following capital structure: Debt: $2,500,000 par value of outstanding bond that pays annually 12% coupon rate with an annual before-tax yield to maturity of 10%. The bond issue has face value of $1,000 and will mature in 25 years. Ordinary shares: 65,000 outstanding ordinary shares. The firm plans to pay a $7.50 dividend per share in the next financial year. The firm is maintaining 3% annual growth rate in dividend, which is expected to continue indefinitely. Preferred shares: 40 000 outstanding preferred shares with face value of $100, paying fixed dividend rate of 14%. Company tax rate is 30%.

Required:

Complete the following tasks: a) Calculate the current price of the corporate bond?

b) Calculate the current price of the ordinary share if the average return of the shares in the same industry is 9%?

c) Calculate the current value of the preferred share if the average return of the shares in the same industry is 12%

d) Calculate the current market value (rounded off to the nearest whole number) and capital structure of the firm (rounded off to two decimal places). Identify the total weights of equity funding

e) Compute the weighted average cost of capital (WACC) under the traditional tax system for the firm, using dividend constant growth model for calculation the cost of ordinary equity (3 marks

No Financial Calculator, Excel Calculations and No Excel files are accepted. You are allowed only one attempt to submit your assignment.

Answer 1

(a) Current Price of Corporate bond

Bond Face Value = $1,000

Coupon Rate = 12% annually

Yield to maturity (before tax) = 10%

Yield to maturity (after tax) = 10% * 0.70 = 7%

Time to Maturity = 25 years

Current Price of Corporate bond = Present Value of all Coupon Amount + Present value of Maturity amount or face value

= Coupon Amount * PVIFA ( 7%,25) + Maturity Amount * PVIF (7%,25)

= 1,000 * 12% * 11.6536 + 1,000 * 0.1842

= 120 * 11.6536 + 184.20

= 1,394.43 + 184.20

= $1,582.63

[ Value of PVIF and PVIFA from respective tables. You can also calculate from following formula-

PVIF = 1 / (1+r)ⁿ PVIFA = { 1 - (1+r)^-n } / r where, r = yield to maturity rate n = number of period ]

(b) Current price of Ordinary Share

D1 = Expected dividend for next year

R = Average return of Shares

  g = growth rate

  

  

= $125

(c) Current Value of Preferred Share

FV = Face Value of Preferred Share

R = Average return of share

  

  

= $116.67

(d)

Before tax Value of debt = (Par value of debt / par value of bond ) * Current price

= ( 2,500,000 / 1,000 ) * 1,582.63

= 2,500 * 1,582.63

= $3,956,575

Value of Debt = $3,956,575 * 0.70 = 2,769,603

Value of Preferred Shares = 40,000 shares * $116.67

= $4,666,800

Value of Equity = 65,000 shares * $125

= $8,125,000

Value of firm = Value of debt + Value of preferred share + Value of Equity

= 2,769,603 + 4,666,800 + 8,125,000

= $15,561,403

(e)

Weight of Equity (We) = 8,125,000 / 15,561,403 = 0.5221

Weight of Preferred Shares (Wp) = 4,666,000 / 15,561,403 = 0.2998

Weight of Debt (Wd) = 2,769,603 / 15,561,403 = 0.1781

Cost

Ke = Dividend / Value of Share = 7.5 / 125 = 0.06 or 6%

Kp = Dividend / Value of preferred Share = 14 / 116.67 = 0.12 or 12%

Kd = YTM (1-tax) = 10 * ( 1 - 0.30 ) = 7%

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

= 0.5221 * 6% + 0.2998 * 12% + 0.1781 * 7%

= 3.1326 + 3.5976 + 1.2467

= 7.9769% or 7.98%