Question

1. Filer Manufacturing has 8.2 million shares of common stock outstanding. The current share price is $52, and the book value per share is $5. Filer Manufacturing also has two bond issues outstanding. The first bond issue has a face value of $70 million, an 8 percent coupon, and sells for 104 percent of par. The second issue has a face value $50 million, a 7.5 percent coupon, and sells for 97 percent of par. The first issue matures in 10 years, the second in 6 years.(assume each unit of bond has a face value of $1,000)

1. What are Filer’s capital structure weights on book value basis?
2. What are Filer’s capital structure weights on a market value basis?
3. Which are more relevant, the book or market value weights? Why?

2. In the previous problem, suppose the most recent dividend was $4 and the dividend growth rate is 6 percent. Assume that the overall cost of debt is the weighted average of that implied by the two outstanding debt issues. Both bonds make semiannual payments. The tax rate is 35 percent. What is the company’s WACC?

Answer 1

a]	Book value weights:
	Component	Book Value in million $	Capital Structure Weights
	Debt [70+50]	$         120.00	74.53%
	Common stock [8.2*$5)	$            41.00	25.47%
	Total	$         161.00
b]	Market value weights:
	Component	Market Value in million $	Capital Structure Weights
	Debt [70*104%+50*97%]	$         121.30	22.15%
	Common stock [8.2*$52)	$         426.40	77.85%
	Total	$         547.70
c]	The market value weight is more relevant. The reason is that it will represent
	the actual position as on the date of analysis and will give the correct WACC.
	If it is based on book values the weight of equity will be too low as is evident
	from [a] and [b] above.
	CALCULATION OF WACC [Using market value weights]:
	Component cost of capital:
	Cost of debt:
	Before tax cost of debt = YTM of the bonds.
	YTM of the bonds using financial calculator:
	YTM of the 1st bond = 7.43%
	YTM of the 2nd bond = 8.14%
	Weighted average YTM:			Weight
	Market value of 1st bond = 70m*104% =	$            72.80	million	60.02%
	Market value of 2nd bond = 50m*97% =	$            48.50	million	39.98%
	Total market value of debt	$         121.30	million
	Weighted average YTM = 7.43%*60.02%+8.14%*39.98% =	7.71%
	After tax cost of debt = 7.71%*(1-35%)	5.01%
	Cost of equity using constant dividend growth formula = 4.00*1.06/52+0.06 =	14.15%
	WACC:
	Component	Market Value	Weight	Component cost	WACC
	Debt	$         121.30	22.15%	5.01%	1.11%
	Common stock	$         426.40	77.85%	14.15%	11.02%
	Total	$         547.70			12.13%
	WACC = 12.13%