Question

Examine the following book-value balance sheet for University Products 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 0.8. There are 1 million common shares outstanding. The market risk premium is 12%, the risk-free rate is 8%, 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 = 6%, paid annually (maturity = 10 years, current yield to maturity = 7%) $ 10.0 Accounts receivable 5.0 Preferred stock (par value $10 per share) 3.0 Inventories 9.0 Common stock (par value $0.40) 0.4 Plant and equipment 21.0 Additional paid-in stockholders’ equity 14.6 Retained earnings 9.0 Total $ 37.0 Total $ 37.0

a. What is the market debt-to-value ratio of the firm?

b. What is University’s WACC?

Answer 1

Answer (a):

Market debt-to-value ratio of the firm = 24.28%

Working:

Number of preferred stock = Book value / par value = 3,000,000 / 10 = 300,000

Number of common stock = Book value / par value = 400,000 / 0.40 =1,000,000

Number of bonds = 10000000 / 1000 = 10,000

We need to get price of bond:

Par value =$1000

Annual coupon = 1000 * 6% = $60

Time to maturity = 10 years

Yield = 7%

Current price = PV (rate, nper, pmt, fv, type) = PV (7%, 10, -60, -1000, 0) =$929.76

Market values and weights are calculated as below:

Answer (b):

WACC = 12.56%

Working:

Cost of common stock = Risk free rate + Beta * Market risk premium = 8% + 0.8 * 12% = 17.60%

Cost of preferred stock = 3 /30 = 10%

Cost of debt = Yield = 7%

WACC = Cost of common stock * Weight of common stock + Cost of preferred stock * Weight of preferred stock + before tax cost of debt * (1 - Tax rate) * weight of debt

= 17.60% * 20000000 / 38297600 + 10% * 9000000 / 38297600 + 7% * (1 - 40%) * 9297600 / 38297600

= 12.56%