Question

Your client wishes you to investigate a telecommunications company with the following balance sheet and details (below): Long-term debt $ Bonds: Par $1,000, annual coupon 7% p.a., 3 years to maturity 10,000,000 Equity Preference shares 5,000,000 Ordinary shares 15,000,000 Total 30,000,000 Notes: The company’s bank has advised that the interest rate on any new debt finance provided for the projects would be 6% p.a. if the debt issue is of similar risk and of the same time to maturity and coupon rate. There are currently 1,000,000 preference shares on issue, which pay a dividend of $0.75 per share. The preference shares currently sell for $5.89. The company’s existing 5,000,000 ordinary shares currently sell for $2.34 each. You have identified that the company has recently paid a $0.35 dividend. Historically, dividends have increased at an annual rate of 2% p.a. and are expected to continue to do so in the future. The company’s tax rate is 30%. Your client wishes to understand, with the use of workings, the following aspects of this company and states that their required rate of return for investment in a company with similar characteristics to this particular company would be 10% p.a. Advise the client on whether you believe this to be a good or bad investment and the rationale for investment (or not investing). a) Determine the market value proportions of debt, preference shares and ordinary equity comprising the company’s capital structure. b) Calculate the after-tax costs of capital for each source of finance. c) Determine the after-tax weighted average cost of capital for the company. d) Indicate, using all applicable information, whether you would recommend this telecommunications company to your client (or not).

The answer posted is incorrect please advise correct answer

Answer 1

K = N

Bond Price =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =3

Bond Price =∑ [(7*1000/100)/(1 + 6/100)^k]     +   1000/(1 + 6/100)^3

k=1

Bond Price = 1026.73

a

MV of equity=Price of equity*number of shares outstanding

MV of equity=2.34*5000000

=11700000

MV of Bond=Par value*bonds outstanding*%age of par

MV of Bond=1000*10000*1.02673

=10267300

MV of Preferred equity=Price*number of shares outstanding

MV of Preferred equity=5.89*1000000

=5890000

MV of firm = MV of Equity + MV of Bond+ MV of Preferred equity

=11700000+10267300+5890000

=27857300

Weight of equity = MV of Equity/MV of firm

Weight of equity = 11700000/27857300

W(E)=0.42

Weight of debt = MV of Bond/MV of firm

Weight of debt = 10267300/27857300

W(D)=0.3686

Weight of preferred equity = MV of preferred equity/MV of firm

Weight of preferred equity = 5890000/27857300

W(PE)=0.2114

b

Cost of equity

As per DDM

Price = recent dividend* (1 + growth rate )/(cost of equity - growth rate)

2.34 = 0.35 * (1+0.02) / (Cost of equity - 0.02)

Cost of equity% = 17.26

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 6*(1-0.3)

= 4.2

cost of preferred equity

cost of preferred equity = Preferred dividend/price*100

cost of preferred equity = 0.75/(5.89)*100

=12.73

c

WACC=after tax cost of debt*W(D)+cost of equity*W(E)+Cost of preferred equity*W(PE)

WACC=4.2*0.3686+17.26*0.42+12.73*0.2114

WACC =11.49%

d

Bad investment as required rate is less than WACC