Question

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

First we will find the cost of different sources of capital--so as to find the WACC

Cost of bonds, rd= after-tax YTM, ie. 12%*(1-40%)=

7.20%

Cost of preferred shares, rps

given the yield as

11.00%

Cost of equity, rs

As per CAPM,

rs=RFR+(Beta*RPM)

10%+(1.5*5%)=

17.50%

As per DCF valuation method,

P0= D1/(r-g)

where P0--is the average $ 20

D1 = Next dividend---ie. D0*(1+g)= 1*(1+0.12)=1.12

r= reqd. return -- needs to be found out--??

g=growth rate, ie. Retention ratio*ROE, ie.(2-1)/2*24%=12% or 0.12

Plugging in the above values, we get the cost of equity, rs as

20=1.12/(r-12%)

rs= 17.6%

Cost of equity according to

Judgemental risk premium model

rs= rd+ JRP

ie. 12%+5%=17%

Workings for market values

Calculation of market values

Market value of bonds

Current market Price for a $ 1000 bond, with 8%/2=4% s/a coupon, for a period of 20*2=40 s/a periods --at the semi-annual yield of 12%/2=6% or 0.06

using the formula, to find PV of bond's cash flows,

Price=((1000*8%/2)*(1-1.06^-40)/0.06))+(1000/1.06^40)=

699.07

so, the market value of the bonds in the balance sheet=

699.07/1000*30000000=

20972100

Market value of Preferred stocks

r ps=$ annual dividend/Market price*(1-5%)

ie. 11%=(2*4)/(MPS*(1-5%)

Solving the above,

Market price/pref. share= $ 76.56

so, the market value of the Pref. shares in the balance sheet=

5000000/100*76.56=

3828000

Market value of common stock

Average price of equity * No.of shares o/s

Recently traded also gives the same result for per share value, ie. (17+23)/2= $ 20 /share

So.mkt. value of equity=20* 4000000=

80000000

So, the weights are

Weight Debt, Wd=Vd/(Vd+Vps+Vs)=20972100/(20972100+3828000+80000000)=

20.01%

Weight, Pref. st.,Wps=Vps/(Vd+Vps+Vs)=3828000/(20972100+3828000+80000000)=

3.65%

Weight, equity,Ws=Ws=Vs/(Vd+Vps+Vs)=80000000/(20972100+3828000+80000000)=

76.34%

So, with the above inputs,

the company’s WACC under the assumption that no new equity will be issued

ie. Cost of equity will be that under DCF method   (not CAPM Or JPM) ----market risks need not be accomodated , as the company is not going to the market.

so, WACC=(Wd*rd)+(wps*rps)+(Ws*rs)

ie.(20.01%*7.20%)+(3.65%*11%)+(76.34%*17.6%)=

15.28%