Question

Cotton On Ltd. currently has the following capital structure:

Debt: $3,500,000 par value of outstanding bond that pays annually 10% coupon rate with an annual

before-tax yield to maturity of 12%. The bond issue has face value of $1,000 and will mature in 20 years.

Ordinary shares: $5,500,000 book value of outstanding ordinary shares. Nominal value of each share is $100. The firm plan just paid a $8.50 dividend per share. The firm is maintaining 4% annual growth rate in dividends, which is expected to continue indefinitely.

Preferred shares: 45,000 outstanding preferred shares with face value of $100, paying fixed dividend rate of 12%

The firm's marginal tax rate is 30%.

Required:
a) Calculate the current price of the corporate bond?
b)Calculate the current price of the ordinary share if the average return of the shares in the same industry is 9%?

c) Calculate the current price of the preferred share if the average return of the shares in the same industry is 10%

Answer 1

a) First of all one need to find after tax YTM
After tax YTM = Before tax YTM(1-tax rate)
= 12%(1-30%)
= 12%(1-0.3)
= 12%(0.7)
= 8.4%
Price of bond = Interest x PVIFA(YTM%,n) + Redemption value x PVIF(YTM%,n)
Interest = 1000 x 10% = 100$
YTM% = 8.4%
n = no of year till maturity = 20
PVIFA(YTM%,n) = [1-(1/(1+r)^n / r ]
PVIFA(8.4%,20) = [1-(1/(1+8.4%)^20 / 8.4%]
=[1-(1/(1+0.084)^20 / 0.084]
=[1-(1/(1.084)^20 / 0.084]
=[1-0.1993 / 0.084]
=0.8007/0.084
=9.5327
PVIF(8.4%,20) = 1/(1+8.4%)^20
=1/(1.084)^20
= 0.19926
Thus price of bond = 100 x 9.5327 + 1000 x 0.19926
= 953.27 + 199.26
= 1152.52 $

b)Price of stock = Dividend of next year/Required rate of return - growth rate
Growth rate = 4%
Required rate of return = 9%
Dividend of next year = Dividend paid(1+ growth rate)
= 8.50(1+4%)
=8.50(1+0.04)
=8.50(1.04)
=8.84$
Thus price of stock = 8.84/9%-4%
=8.84/5%
=176.80 $

c) Price of preference shares = Dividend/Required rate of return
Dividend = 100 x 12% = 12$
Required rate of return = 10%
Thus price of preference shares = 12/10%
=120$