Question

In: Finance

Plastic Parts Co. is a publicly traded company. Its beta is 0.85. The market risk premium...

Plastic Parts Co. is a publicly traded company. Its beta is 0.85. The market risk premium is 11.5% and T-bills are yielding 2.2%. PPC just paid a dividend of $1.15 and its stock is trading at $22. Analyst consensus is that PPC dividends should grow at 6%.

PPC has 20 million common shares outstanding.

The firm has a $15 million bank loan that is held at the bank (the loan is not trading on a secondary market) at 6.25% APR. It pays the bank interest annually.

PPC has a $100 million bond outstanding. The bond has 5 years to maturity, is trading at 110, and has a coupon of 8%. PPC pays interest on the bond semi-annually.

PPC’s tax rate is 35%.

a.If you compare PPC to another plastics/ chemical firm that has a beta of 1.1, which would be considered the “riskier” stock? Why?

b.How does PPC’s risk premium compare to the market risk premium?

c.You have a stock portfolio with a beta of 1.27. What is the expected return of your portfolio? (Hint: Use the CAMP to estimate the expected return of your portfolio)

d.You want to decrease the risk in your portfolio and decide to diversify by adding PPC to your portfolio. PPC will represent 5% of your new portfolio. What is the expected return of the new portfolio once you add PPC?

e.You are an analyst who must estimate an expected return for PPC shares over the coming year. What is a reasonable estimate given the above information (HINT: an expected return is the same as the cost of equity capital, and a reasonable estimate of the cost of equity capital is the average of the dividend model and the CAPM models).

f.What is the market capitalization of PPC common equity?

g.What is the cost of private (loan) debt?

h.What is the firm’s enterprise value?

i.Calculate the capital structure weights for:

1)What is the capital structure weight for equity capital?

2)What is the capital structure weight for bond capital?

3)What is the capital structure weight for loan capital?

4)What is PPC's WACC?

Solutions

Expert Solution

a] The other comparable firm is riskier as it has a higher beta.
Beta is a measure of the systematic risk a firm. The higher
the beta the higher the systematic risk.
b] PPC's risk premium = 11.5%*0.85 = 9.78%
PPC's risk premium is lower than the risk premium of the
market by 172 basis points.
c] Expected return of the portfolio = risk free rate+beta*market risk premium = 2.2%+1.27*11.5% = 16.81%
d] Revised portfolio beta = 1.27*95%+0.85*5% = 1.25
Revised expected portfolio return = 2.2%+1.25*11.5% = 16.58%
e] Cost of equity per CAPM = 2.2%+0.85*11.5% = 11.98%
Cost of equity per dividend discount model = 1.15*1.06/22+0.06 = 11.54%
Average cost of equity = (11.98%+11.54%)/2 = 11.76%
f] Market capitalization of common equity = number of equity shares*price per share = 20000000*22 = $    44,00,00,000
g] Cost of private loan [after tax] = 6.25%*(1-35%) = 4.06%
h] Firm's enterprise value =
MV of common equity+MV of debt+MV of bonds.
Component Market Value
Private loan [Loan amount, as it is not traded] $      1,50,00,000
Bond capital [100000000*110%] $    11,00,00,000
Common stock [equity] $    44,00,00,000
Total $    56,50,00,000
Enterprise value = $    56,50,00,000
i] Component Market Value Capital Structure Weight
1] Common stock [equity] $    44,00,00,000 77.88%
2] Bond capital [100000000*110%] $    11,00,00,000 19.47%
3] Private loan [Loan amount, as it is not traded] $      1,50,00,000 2.65%
Total $    56,50,00,000 100.00%
4] Before tax cost of bond = YTM.
YTM using a calculator = 3.55%
After tax cost of bond = 3.55%*(1-35%) = 2.31%
CALCULATION OF WACC:
Component Market Value Capital Structure Weight Component Cost of Capital WACC
Common stock [equity] $    44,00,00,000 77.88% 11.76% 9.16%
Bond capital [100000000*110%] $    11,00,00,000 19.47% 2.31% 0.45%
Private loan [Loan amount, as it is not traded] $      1,50,00,000 2.65% 4.06% 0.11%
Total $    56,50,00,000 100.00% 9.72%
WACC = 9.72%

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