Question

Use the information below to determine the security prices and cost of capital for the ABC Inc that uses the following capital structure.

Debt: the firm has 43,094 bonds which have 15 years to maturity, pay an annual coupon of 12% and have a face value of $1000. The current YTM on comparable bonds is 9%.

Equity: the firm has 1,000,000 shares of common stock, which is expected to pay a dividend per share of $1.00 in year 1, a dividend per share of $2.00 in year 2, and a dividend of $3.00 in year 3. After year 3, dividends are expected to grow at the rate of 3% per year indefinitely. The market risk premium (rm-rf) is 7% and the risk free rate is 3%. The firm’s equity beta is 1.5. The relevant tax rate is 30%

What is the market value of the firm’ bonds and stock, and its total market value?

What is the firm’s WACC (Weighted Average Cost of Capital)?

Answer 1

Lets calculate the market value of the debt:

C= 12% of 1000 = 120

YTM = 9%

n =15

P= 1000

Using excel and above formula to calculate the values:

Summation for the 15 years = 967.283

Discounted Principal = 274.538

So total return from the bond = 1241.821

Market Value of Debt = 1241.821 * 43094 =  53515019.22

Now lets calculate the MV of equity:

Using CAPM , 3% + 1.5*7% = 13.5% = 0.135

So equity price (as dividends are 1,2,3 for the first three years respectively, and then a growth of 3% indefnitely)

Dividend after 3 years = 3 +0.03*3 = 3.09

1/ (1+ 0.135) + 2/ (1+0.135)^2 +3 / (1+0.135)^3 + 3.09 / ((0.135-0.03) (1+0.135)^3) = 24.61

MV of Equity = 24.61 * 1,000,000 = 24610000

Total MV = 24610000 + 53515019.22 = 78125019.22

(B) Weight of Equity = 0. 3150

Weight of debt = 0.6849

Tax = 30%

WACC = (Cost of Equity * Wt. of Equity) + (Cost of Debt*Wt. of debt*(1-Tax rate))

13.5% * 0.315 + 9% * 0.6849*(1-0.3 ) = 8.5674%

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