Question

Firm A plans to finance the project from the following sources:

Debt:

Outstanding bonds of firms of similar risk and maturity as Firm B have an annual coupon of 5.75 percent, paid semiannually, mature in 15 years, and currently sell for $855. The firm’s marginal tax rate is 21%.

Common Stock:

The most recent dividend on the common shares, D0 was $1.20 and that dividend is expected to grow at 2 percent per year. The expected issue price is $15.00.

1. If Firm A intends to issue 15 year bonds to fund this project, what is the best estimate of the firm's borrowing cost? Answer should be in decimals.

2. Use the dividend discount model discussed in the PP slides to estimate the cost of common stock (the required rate of return on the stock). Answer should be in decimals (0.001).

3. The following information reflects market values of Firm A’s capital structure.

• Assets $54,380
• Debt $20,664

_____________ percent of the firm is financed with equity. Answer should be a number (33).

4. Assuming Firm A wants to maintain is current capital structure, estimate the project's weighted average cost of capital.

Answer 1

1.

kd=(Interest net of tax+(Redemption price-Current price)/time)/(Redemptionn price+Issue price)/2

    =(1000*0.0575*(1-0.21)+(1000-855)/15)/(1000+855)/2

    =55.09/927.50

    5.94%

2.

Price today= Future dividend/Required retun-Growth

15=1.20*1.02/(Required return-0.02)

Required return= 10.16%

Future dividend= Present dividend*(1+Growth)

3.

Equity=54380

Debt=20664

Total=75044

Equity= Equity/Total

          =54380/75044

         72.47%

4.

WACC= Weight of debt*Cost of debt + Weight of equity*Cost of equity

           =0.2753*0.0594 + 0.7247*0.1016

           =8.9979%