Question

In: Finance

A company, which produces and sells dairy products, has the following capital structure: Security Type Number...

A company, which produces and sells dairy products, has the following capital structure:

Security Type

Number of Security Outstanding

Market Price for Each Unit

Bond:

coupon rate is 0%, face value is $1,000, matures in 10 years, interest compounds annually

200,000

$880

Ordinary Share:

beta of the stock is 0.95

160,000

$55

         The corporate tax rate is 29%. The risk-free rate of return is 2.2%, and the market risk premium is 13%. The company generally uses the weighted average cost of capital (WACC) as the discount rate for all projects.

         The company is planning to initiate a software development project. The software will educate customers about the nutritional values of its dairy production. To fund the project, the company is planning to issue 110,000 preference shares with a yearly dividend of $2.5 per share.

  1. Do you think using WACC as a discount rate to evaluate the new project will be the right choice? Why or why not? Explain.
  2. Determine the WACC of the company before issuing the preference shares.
  3. Determine the WACC of the company after issuing the preference shares. Assume the preference shares will sell in the market for $50 per share, and the market prices of other securities will remain the same after the issue of preference shares.
  4. If the company issues 250,000 new zero-coupon bonds with the face value, maturity, and interest compounding as its current bond issue, how will its cost of debt change?                                             

Solutions

Expert Solution

a) Discounting with WACC for a new project is right chice . WACC is minimum weighted expected rate of return from the project. Normally valuation of company or new project is done with WACC. A project can finance either throgh equity or debt or mix , so WACC will consider all source of finance and its cost.

b) asssuming Share facevalue 1000 which is not given

Before Pref share

Cost of bond = 0%

Cost of Equity using CAPM

Rf = 2.2

Market Risk Premium = 13 %

Beta = .95

Cost of Equity = Rf+ (Beta*Risk Premium)

2.2+(.95*13)= 14.55

c) assuming facevalue 1000

divident = 2.5

cost of pref. share = dividend/ market price = 2.5/ 50 x100 = 5%

WACC after Pref Share Issue

d)if the company issue ZCB coupon rate is zero as bond so cost of debt will not cahnge but WACC will change because of change in proportion

jeff jeffy answered 1 year ago
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