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A company has the following capital structure. 50,000 shares of common stocks outstanding, trading at Pcs,0...

A company has the following capital structure.

  • 50,000 shares of common stocks outstanding, trading at Pcs,0 =$10 per share. The company’s period 0 dividend per share is 0.5 dollars and is expected to grow by 10% per year.
  • 20,000 shares of preferred stocks trading at Pps,0 =$5 per share, that pays a 0.5 dollar dividend per share.
  • The company also sold a 20-year non-amortized corporate bond worth 1 million at par in period 0, with a yield to maturity (YTM) of 5%. The corporation faces a tax rate of τ =25%
    1. In period 1, shortly after dividends are paid to the preferred stockholders, the company borrowsa 10-year term amortized bank loan at APR of 5%, and uses the proceeds of which to buy back (retire) outstanding preferred stocks at a price of Pps,1 =5.25 dollars per share. Following this news, the price of common stocks drops to Pcs,1 =9.5 dollars per share in period 1.
      1. What’s the actual rate of return to an investor who bought one share of preferred stock inperiod 0, and sells it back to the company in period 1? (Hint: do not forget dividends).
      2. The financial market now believes that the company will deliver a dividend growth rate of12% in the future. According to the Constant Dividend Growth Model, what’s the rate of return required by the common stock shareholder in period 1? Denote this number by rcs,1
      3. What’s the company’s WACC in period 1?

Solutions

Expert Solution

a
A Investment in preference share in period=0 $5
B Dividend received at period=1 $0.50
C Amount received from sale of share $5.25
D=B+C Total amount received at period=1 $5.75
E=(D/A)-1 Actual Return to the investor 0.15 ((5.75/5)-1)
Actual Return to the investor 15.00%
b
D0 Dividend in period 0 $0.50
g Growth rate =10%= 0.1
D1=D0*(1+g) Dividend in period 1=0.5*(1+0.1) $0.55
g1 New growth Rate after period1=12% 0.12
D2=D1*(1+g1) Dividend in period 2=0.55*(1+0.12) $0.62
R Required rate of return
P1 Price of stock in period 1 $9.50
P1=D2/(R-g1)
R=(D2/P1)+g1
R Required rate of return=(0.62/9.5)+0.12 0.18484211
Required Rate of Return 18.5%
c WACC of the company in period 1
Me Market Value of Equity=50000*9.5 $475,000
Market Value of Debt:
20 year corporate bond $1,000,000
10 year bank loan=20000*5.5 $110,000
Md Market Value of total debt $1,110,000
M=Me+Md Market Value of total capital $1,585,000
We=Me/M Weight of Equity=475000/1585000= 0.29968454
Wd=Md/M Weight of Debt=110000/1585000= 0.70031546
Ce Cost of Equity =Required Return 18.5%
Cd Cost of Debt =5*(1-0.25)= 3.75%
WACC=We*Ce+Wd*Cd= 8.2%

jeff jeffy answered 2 years ago
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