Question

Examine the following book-value balance sheet for Toys INC. The preferred stock currently sells for $30 per share and pays a dividend of $3 a share. The common stock sells for $20 per share and has a beta of 0.6. There are 3 million common shares outstanding. The market risk premium is 9%, the risk-free rate is 5%, and the firm’s tax rate is 40%.

BOOK-VALUE BALANCE SHEET
(Figures in $ millions)
Assets					Liabilities and Net Worth
Cash and short-term securities	$	2.0			Bonds, coupon = 8%, paid annually (maturity = 10 years, current yield to maturity = 9%)	$	10.0
Accounts receivable		5.0			Preferred stock (par value $20 per share)		3.0
Inventories		9.0			Common stock (par value $0.10)		0.3
Plant and equipment		26.0			Additional paid-in stockholders’ equity		16.7
					Retained earnings		12.0
Total	$	42.0			Total	$	42.0

a. What is the market debt-to-value ratio of the firm? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

b. What is Toys WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Answer 1

a

K = N

MV/book of debt =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =10

=∑ [(8*100/100)/(1 + 9/100)^k]     +   100/(1 + 9/100)^10

k=1

= 93.58%

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

MV of equity=20*3000000

=60000000

MV of Bond=Par value*bonds outstanding*MV to book of debt

MV of Bond=1000*10000*0.9358

=9358000

MV of Preferred equity=Price*number of shares outstanding

MV of Preferred equity=30*150000

=4500000

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

=60000000+9358000+4500000

=73858000

MV of debt to firm value = 9358000/73858000=12.67%

b

Weight of equity = MV of Equity/MV of firm

Weight of equity = 60000000/73858000

W(E)=0.8124

Weight of debt = MV of Bond/MV of firm

Weight of debt = 9358000/73858000

W(D)=0.1267

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

Weight of preferred equity = 4500000/73858000

W(PE)=0.0609

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (Market risk premium)

Cost of equity% = 5 + 0.6 * (9)

Cost of equity% = 10.4

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

After tax cost of debt = 9*(1-0.4)

= 5.4

cost of preferred equity

cost of preferred equity = Preferred dividend/price*100

cost of preferred equity = 3/(30)*100

=10

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

WACC=5.4*0.1267+10.4*0.8124+10*0.0609

WACC =9.74%