Question

Company Jedi AB has 10 million shares of equity outstanding. The current share price is 50 SEK, and the book value per share is 5 SEK.

The company also has two bond issues outstanding. The first bond issue has a face value of 100Million SEK (MSEK) and a 10 per cent annual coupon payment , sells for 90 per cent of par (face value of 1,000SEK), and matures in 1 year.

The second issue has a face value of £60 million and a 7.5 per cent annual coupon paymentand sells for 96.5 per cent of par. The first issue matures in 10 years, the second in 6 years.

Note that in both bonds, there will be one coupon payment and face value.

Suppose the company’s equity has a beta of 2. The risk-free rate is 6 per cent, and the expected return on the market is 16 per cent. Assume that the overall cost of debt is the weighted average implied by the two outstanding debt issues. Both bonds make semi-annual payments. The tax rate is 35 per cent.

Calculate:

1. Return of Equity
2. YTM of each bond
3. The weighted average after-tax cost of debt
4. Company’s WACC?

Answer 1

As per CAPM return on equity = Risk free rate + ( Return on market - risk free rate ) * beta

= 6 + ( 16-6) * 2 = 6 + 10*2 = 26%

Now Price of the bond = sum of presnt value of cashflows

For 1st issue , let the ytm be r1

1000*90% = 1000 / ( 1+r1 + 100 / ( 1+ r1

900 = 1100 / ( 1+r1

1+r1= 1100 / 900

1 + r1= 1.2222

r 1 = 22.22%

ytm of 1st issue bond = 22.22%

For 2nd issue of bonds , let the ytm be r2

1000 * 96.5% = 1000 / ( 1 +r2) + 75 / ( 1 + r2)

965 = 1075 / ( 1 + r2)

r2 = 1075/ 965 - 1 = 11.40%

ytm of 2nd issue bond = 11.40%

Value of bond 1 = 90% of 100 = 90 M SEK

Value of bond 2 = 96.5% of 60 = 57.90 M SEK

Value of equity =Current share price * No of shares outsanding = 10* 50 = 500 M SEK

The weighted average after tax cost of debt

= [eight of bond1 * ytm of bond 1 + weight of bond 2*ytm of bond 2 ]* ( 1 - tax rate )

=[90 / ( 90+ 57.9) * 22.22 + 57.9 / ( 90 + 57.9) * 11.40 ] * ( 1 - 0.35)

=[0.608519 * 22.22 + 0.391481*11.40 ] * 0.65

= 17.9842 * 0.65

=11.69%

Company's WACC = Weight of equity * return on equity + weight on debt * after tax cost of debt

= 500 / ( 500 + 57.9+90) * 26 + ( 90+57.9 ) / ( 500 + 57.9 +100 ) * 11.69

= 500/ 647.9 * 26 + 147.90 / 647.90 * 11.69

= 20.0648 + 2.6685

= 22.73%