Question

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

Travellers Inn: December 31, 2013 (Millions of Dollars)

Cash	$ 10	Accounts payable	$ 10
Accounts receivable	20	Accruals	10
Inventories	20	Short-term debt	5
Current assets	$ 50	Current liabilities	$ 25
Net fixed assets	50	Long-term debt	30
		Preferred stock	5
		Common equity
		Common stock	$ 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 20-year, semiannual payment mortgage bonds with a coupon rate of 8%. Currently, these bonds provide a yield to investors of r_d = 12%. If new bonds were sold, they would have a 12% yield to maturity.

(2) TII’s perpetual preferred stock has a $100 par value, pays a quarterly dividend of $2, and has a yield to investors of 11%. New perpetual preferred stock would have to provide the same yield to investors, and the company would incur a 5% flotation cost to sell it.

(3) The company has 4 million shares of common stock outstanding. P₀ = $20, but the stock has recently traded in the price range from $17 to $23. D₀ = $1 and EPS₀ = $2. ROE based on average equity was 24% in 2012, but management expects to increase this return on equity to 30%; however, security analysts and investors generally are not aware of management’s optimism in this regard.

(4) Betas, as reported by security analysts, is 1.5; the T-bond rate is 10%; and RP_M is estimated by various brokerage houses 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 12%. The responses suggested a risk premium over TII bonds of 5 percentage points.

(6) TII is in the 40% 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.

Answer 1

		Value	Cost	WACC
	Total common equity	40	30%	12
	Preferred stock (Note 2)	5	8.2%	0.4
	Long term debt	30	8%	2.4
	WACC			14.8
		WACC = 14.8%
1. Long term debt
	From company point of view, the cost for company is what they have to pay, not the yield to maturity for investor.
2. Cost of preferred stock
	Par value	100
	Flotation cost - 5%
	Amount received= 100 - 5%	95
	yearly dividend = 2 * 4 quarter	8
	Cost of preferred stock =	8/(100 + 95)/2
		8/97.5
		8.2%
3. Cost of common stock
	Total no. of shares	4000000
	EPS	2
	Total Profit	8000000
	Return on equity	24%
	Management expect to increase ROE	30%
	Thus cost of equity	30%
	Reserves is also forming part of equity