Question

Consider the following information on Budget Plc:

Debt: 80,000 9 coupon bonds outstanding with par value of $1,000 and 18 years to maturity, selling for 108 percent of par, the bonds make semiannual payments.

Common stock: 415,000 shares outstanding, selling for $65 per share: the beta is 1.25

Preferred stock: 100,000 shares of 4.5 percent preferred stock outstanding, currently selling for $103 per share (par value=100)

Market: 8 percent market risk premium and 2.8 percent risk free rate.

Assume the company's tax rate is 35 percent.

1) Calculate the market value of each component of the capital structure (Debt, common stock, and preferred sfock) as well as the total market value of the firm.

2) Calculate the cost of equity.

3) Calculate the after tax cost of debt.

4) Calculate the cost of preferred stock.

5) Calculate the weighted average cost of capital (WACC)

Answer 1

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

MV of equity=65*415000

=26975000

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

MV of Bond=1000*80000*1.08

=86400000

MV of Preferred equity=Price*number of shares outstanding

MV of Preferred equity=103*100000

=10300000

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

=26975000+86400000+10300000

=123675000

Weight of equity = MV of Equity/MV of firm

Weight of equity = 26975000/123675000

W(E)=0.2181

Weight of debt = MV of Bond/MV of firm

Weight of debt = 86400000/123675000

W(D)=0.6986

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

Weight of preferred equity = 10300000/123675000

W(PE)=0.0833

2) Cost of equity

As per CAPM

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

Cost of equity% = 2.8 + 1.25 * (8)

Cost of equity% = 12.8

3)Cost of debt

K = Nx2

Bond Price =∑ [(Semi Annual Coupon)/(1 + YTM/2)^k]     +   Par value/(1 + YTM/2)^Nx2

k=1

K =18x2

1080 =∑ [(9*1000/200)/(1 + YTM/200)^k]     +   1000/(1 + YTM/200)^18x2

k=1

YTM = 8.1452785492

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

After tax cost of debt = 8.1452785492*(1-0.35)

= 5.29443105698

4) cost of preferred equity

cost of preferred equity = Preferred dividend/price*100

cost of preferred equity = 4.5/(103)*100

=4.37

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

WACC=5.29*0.6986+12.8*0.2181+4.37*0.0833

WACC =6.85%