Question

Lisa is considering and investment into the z ltd. The company has following capital structure:

• 5 million value 12% coupon bond paying interest semi-annually. The bonds have face value of $1000 and will be mature in 13 years from now. The yield to maturity for the bond is 12.5%
• 40000 outstanding ordinary share which just paid a dividend of $5 per share. The recent financial statement of the company announced a steady growth of 8% per year in their dividend payout policy. The re quired rate of return for shares of this type is 16%

Required

1. Calculate the current value of the bond
2. Calculate the current value of the share
3. Calculate the current total market value of the firm?
4. Calculate the capital structure of the firm by identifying weight of debt financing and weight of equity financing?
5. Compute the weighted average cost of capital (WACC) under the traditional tax system for the firm, using dividend constant growth model for calculation the cost of equity.
6. Assume that the company decided to convert their bond to a preference share with the same face value which promises an income of 10% fixed dividend each year. Compute the present value of the preference share is expected return of the same type of preference share is 9%

Answer 1

You have asked a very long question with multiple sub parts. I will address the first four sub parts. Please post the balance sub parts as a separate question.

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Calculate the current value of the bond

We will calculate the value of one bond using PV function of excel. Please note that payments are on semi annual basis. Hence one period is one half year.

Inputs for PV function will be:

Rate = YTM per period = 12.5% / 2 = 6.25%

Period = nos. of half year in 13 years to maturity = 2 x 13 = 26

PMT = Payment per period = semi annual coupon = 12% / 2 x Par value = 12% / 2 x 1,000 = 60

FV = future value = par value = 1000

Hence, current value of one bond = - PV (Rate, Period, PMT, FV) = - PV (6.25%, 26, 60, 1000) = $ 968.27

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Calculate the current value of the share

D0 = 5, g = 8%, Cost of equity, Ke = 16%

Hence, value of one share = D0 x (1 + g) / (Ke - g) = 5 x (1 + 8%) / (16% - 8%) = $  67.50

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Calculate the current total market value of the firm?

Hence, pre tax cost of debt, Kd = Annual yield = 2 x semi annual yield = 2 x 2.85% = 5.70%

Market value of debt, D = Number of bonds outstanding x Current price = Book Value / Face Value x Current Price = 5,000,000 / 1,000 x 968.27 = $ 4,841,350

Market value of equity, E = Price x number of shares outstanding = 67.50 x 40,000 = $ 2,700,000

Hence, total market value of the firm, V = D + E =  4,841,350 + 2,700,000 = 7,541,350

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Calculate the capital structure of the firm by identifying weight of debt financing and weight of equity financing?

Proportion of debt, Wd = D / V = 4,841,350 / 7,541,350 = 64.20%

Proportion of equity, We = E / V = 1 - D / V = 1 - Wd = 1 - 64.20% = 35.80%

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Please post the balance sub parts as separate question. Also please note that we will need the coporate tax rate for calculation of WACC. There is no mention of tax rate in your question. Please check the question at your end for any ommission.