a)
To determine: The market value of the capital structure.
a)
Answer to Problem 16QP
The market value of the capital structure is $484,220,000.
Explanation of Solution
Given information:
Company T has an outstanding bond issue. The bond has a face value of $1,000 and a coupon rate of 6.5 percent. The company issued 120,000 bonds. The bonds mature in 15 years and make semiannual coupon payments. The bonds sell at 107 percent of the face value in the market.
It has 7,300,000 common equity shares outstanding. The market price of the share is $46. The stock has a beta of 0.95. The company has also issued preferred stock. There are 220,000 outstanding preference shares. The dividend per share is 4.5 percent and its current market value is $91 per share. The market risk premium is 7 percent, and the risk-free rate is 3.6 percent. The tax rate applicable is 35 percent.
The formula to calculate the market value of equity:
The formula to calculate the market value of preferred stock:
The formula to calculate the market value of debt:
The formula to calculate the total market value of the capital structure:
Compute the market value of equity:
Hence, the market value of equity is $335,800,000.
Compute the market value of preferred stock:
Hence, the market value of preferred stock is $20,020,000.
Compute the market value of debt:
Hence, the market value of debt is $128,400,000.
The formula to calculate the total market value of the capital structure:
Hence, the total market value of the capital structure is $484,220,000.
b)
To determine: The discount rate.
Introduction:
The weighted average cost of capital (WACC) refers to the weighted average of the cost of debt after taxes and the
b)
Answer to Problem 16QP
The weighted average cost of capital is 8.31 percent. It is the return based on the risk of the firm. If the proposed project has a risk similar to that of the firm, then it can use the weighted average cost of capital as the discount rate.
Explanation of Solution
Given information:
Company T has an outstanding bond issue. The bond has a face value of $1,000 and a coupon rate of 6.5 percent. The company issued 120,000 bonds. The bonds mature in 15 years and make semiannual coupon payments. The bonds sell at 107 percent of the face value in the market.
It has 7,300,000 common equity shares outstanding. The market price of the share is $46. The stock has a beta of 0.95. The company has also issued preferred stock. There are 220,000 outstanding preference shares. The dividend per share is 4.5 percent and its current market value is $91 per share. The market risk premium is 7 percent, and the risk-free rate is 3.6 percent. The tax rate applicable is 35 percent.
The formula to calculate annual coupon payment:
The formula to calculate the current price:
The formula to calculate the yield to maturity:
Where,
“C” refers to the coupon paid per period
“F” refers to the face value paid at maturity
“r” refers to the yield to maturity
“t” refers to the periods to maturity
The formula to calculate the cost of equity under the Security market line (SML) approach:
Where,
“RE” refers to the expected
“Rf” refers to the risk-free rate
“RM” refers to the expected return on the market portfolio
“(RM−Rf)” refers to the market risk premium
“βE” refers to the beta or risk of the equity
The formula to calculate the cost of preferred stock:
Where,
“RP” refers to the return on preferred stock or cost of preferred stock
“D” refers to the dividend earned on the preferred stock
“P0” refers to the current price of preference stock
The formula to calculate the weighted average cost of capital:
Where,
“WACC” refers to the weighted average cost of capital
“RE” refers to the return on equity
“RP” refers to the return on preferred equity
“RD” refers to the return on debt
“E” refers to the amount of common equity capital
“P” refers to the amount of preferred equity
“D” refers to the amount of debt
“V” refers to the total amount of capital
“TC” refers to the corporate tax rate
Compute the annual coupon payment:
Hence, the annual coupon payment is $65.
Compute the current price of the bond:
The face value of the bond is $1,000. The bond value is 107% of the face value of the bond.
Hence, the current price of the bond is $1,070.
Compute the semiannual yield to maturity of the bond as follows:
The bond pays the coupons semiannually. The annual coupon payment is $65. However, the bondholder will receive the same is two equal installments. Hence, semiannual coupon payment or the 6-month coupon payment is $32.5
The remaining time to maturity is 15 years. As the coupon payment is semiannual, the semiannual periods to maturity are 30
Finding “r” in Equation (1) would give the semiannual yield to maturity. However, it is difficult to simplify the above the equation. Hence, the only method to solve for “r” is the trial and error method.
The first step in trial and error method is to identify the discount rate that needs to be used. The bond sells at a premium in the market if the market rates (Yield to maturity) are lower than the coupon rate. Similarly, the bond sells at a discount if the market rate (Yield to maturity) is greater than the coupon rate.
In the given information, the bond sells at a premium because the market value of the bond is higher than its face value. Hence, substitute “r” with a rate that is lower than the coupon rate until one obtains the bond value close to $1,070.
The coupon rate of 6.5 percent is an annual rate. The semiannual coupon rate is 3.25 percent
The attempt under the trial and error method using 2.9 percent as “r”:
The current price of the bond is $1,069.50 when “r” is 2.9 percent. This value is close to the bond value of $1,070. Hence, 2.9 percent is the semiannual yield to maturity.
Compute the annual yield to maturity:
Hence, the yield to maturity is 5.8 percent.
Compute the cost of equity:
Hence, the cost of equity is 10.25 percent.
Compute the cost of preferred stock:
Assume that the face value of one preferred stock is $100. At 4.5 percent, the dividend on preferred stock is $4.5
Hence, the cost of preferred stock is 4.95 percent.
Compute the weighted average cost of capital:
Hence, the weighted average cost of capital is 8.31 percent.
Want to see more full solutions like this?
Chapter 14 Solutions
Fundamentals of Corporate Finance
- 12. Finding the WACC Titan Mining Corporation has 6.4 million shares of common stock outstanding and 175,000 6.2 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $53 per share and has a beta of 1.15; the bonds have 25 years to maturity and sell for 106 percent of par. The market risk premium is 6.8 percent, T-bills are yielding 3.1 percent, and the company's tax rate is 22 percent. a. What is the firm's market value capital structure? b. If the company is evaluating a new investment project that has the same risk as the firm's typical project, what rate should the firm use to discount the project's cash flows?arrow_forwardtock Dividends [LO3] The market value balance sheet for Vena Sera Manufacturing is shown here. Vena Sera has declared a 25 percent stock dividend. The stock goes ex dividend tomorrow (the chronology for a stock dividend is similar to that for a cash dividend). There are 12,000 shares of stock outstanding. What will the ex-dividend price be? Market Value Balance Sheet CashFixed assets Total $ 38,500 270,000 $308,500 Equity Total $308,500 $308,500 Market Value Balance Sheet CashFixed assets Total $ 93,000 509,000 $602,000 Debt Equity Total $131,000 471,000 $602,000arrow_forwardQUESTION 17 If a company has 2240 million shares outstanding and each share is worth AUD 3.60 the market capitalization (value of the company) is million AUD. The company seeks to raise AUD 728 million by selling new shares with a subscription price of AUD 2.60, therefore it has to issue million new shares. After issuing these new shares successfully its new market capitalization will be million AUD and the total amount of shares will grow to million. As a result the value of each share after the issue will be AUD. The difference between the subscription price and the share price after the issue is AUD. Therefore, it is worth to pay up to AUD for the RIGHT to buy shares at AUD 2.60. Compare the old share price with the share price after the issue. It dropped by AUD. The ratio of the number of old shares to newly issued shares is exactly . This is also the number of old shares you need to get ONE RIGHT for a new share. HINT: Check if old shareholders' losses can be recovered by selling…arrow_forward
- Calculating Market Value Ratios [LO2] Bach Corp. had additions to retainedearnings for the year just ended of $430,000. The fi rm paid out $175,000 in cashdividends, and it has ending total equity of $5.3 million. If the company currentlyhas 210,000 shares of common stock outstanding, what are earnings per share?Dividends per share? Book value per share? If the stock currently sells for $63 pershare, what is the market-to-book ratio? The price–earnings ratio? If the companyhad sales of $4.5 million, what is the price–sales ratio?arrow_forwardUsing Stock Quotes [LO3] You have found the following stock quote for RJW Enterprises, Inc., in the financial pages of today's newspaper. What was the closing price for this stock that appeared in yesterday's paper? If the company currently hasi 25 million shares of stock outstanding, what was net income for the most recent four quarters? 19. 52-WEEK YLD VOL 100s NET HI LO STOCK (DIV) PE CLOSE CHG 72.18 53.17 RJW 1.48 2.1 19 17652 ?? -23arrow_forwardQuestion 1 DMC currently has 100,000 shares of common stock outstanding with a market price of $50 per share. It also has $2 million in 7% bonds currently selling at par. The company is considering a $4 million expansion program that it can finance either (I) all common stock at $50 per share, or (II) all bonds at 9%. The company estimates that if the expansion is undertaken, it can attain, in the near future, $1 million EBIT. The company’s tax rate is 40%. Calculate EPS for each plan. Draw the EBIT-EPS graph. What is the break-even or indifference point between the two alternatives? Due to expansionary credit conditions / monetary policy, you expect that sales and EBIT next year would be greater than the break-even calculated in © above, what form of financing would you recommend? Which plan is riskier, I or II? Why?arrow_forward
- [EXCEL] Cost of common stock: Whitewall Tire Co. just paid an annual dividend of $1.60 on its common shares. If Whitewall is expected to increase its annual dividend by 2 percent per year into the foreseeable future and the current price of Whitewall's common shares is $11.66, what is the cost of common stock for Whitewall? please use excelarrow_forward1. Rights Offerings [LO4] Leah, Inc., is proposing a rights offering. Presently there are 375,000 shares outstanding at $67 each. There will be 50,000 new shares offered at $58 each. a. What is the new market value of the company? b. How many rights are associated with one of the new shares? c. What is the ex-rights price? d. What is the value of a right? e. Why might a company have a rights offering rather than a general cash offer?arrow_forwardQ13 The Engineering Company currently has 100,000 outstanding stocks selling at OMR 100 each. The firm has net profits of OMR 1,000,000 and wants to make new investments of OMR 2,000,000 during the period. The firm is also thinking of declaring a dividend of OMR 5 per share at the end of the current fiscal year. The market price of per stock at the end of the current year is expected to be OMR 120. How many number new stocks to be issued by the firm assume that dividend is declared under MM model? a. 10,000 stocks b. 15,000 stocks c. 20,000 stocks d. 12,500 stocksarrow_forward
- 3. Calculating Cost of Equity [LO1] Stock in Daenerys Industries has a beta of 1.05. The market risk premium is 7 percent, and T-bills are currently yielding 3.4 percent. The company's most recent dividend was $2.35 per share, and dividends are expected to grow at an annual rate of 4.1 percent indefinitely. If the stock sells for $43 per share, what is your best estimate of the company's cost of equity?arrow_forwardQuestion 2 Bintang Industry is seeking your financial advice to determine the firm’s cost of capital. The following data are given to you: 20 years bond with 12 percent coupon was issued 10 years ago and is currently selling at RM1,153. The firm’s tax bracket is 40 percent and its floatation cost is 20 percent of par value. Par value is RM1,000. The current price of its preferred share is RM1.30 issued with a dividend of 10 percent of par value of RM1. Floatation cost is 10 percent of its current price. Bintang’s stock is currently selling at RM5 per share. The expected dividend for next year is RM0.44 and it is expected to grow at a constant rate of 5 percent. 1. Calculate the after-tax cost of its: a) Debt b) Preferred Share c) Equity 2. Calculate the weighted average cost of capital (WACC) if the ratio is as follows: Debt 30 percent Preferred share 20 percent Equity 50 percent.arrow_forward12 [Question text] Aqil has invested in twelve different stocks that have a combined value today of RM121,300. 15 percent of that total is invested in Wise Man Foods. The 15 percent is a measure of __________________________. Select one: A. price-earnings ratio B. degree of risk C. portfolio weight D. portfolio returnarrow_forward
- Intermediate Financial Management (MindTap Course...FinanceISBN:9781337395083Author:Eugene F. Brigham, Phillip R. DavesPublisher:Cengage Learning