Question

You are provided the following information:

Capital Structure:

Debt                                         $    60000

Equity                                       $   180000

The firm sold 50 year; $ 1000 face value, 5% bonds 10 years ago. These bonds trade at $ 930. You expect the yield on these bonds to be a good proxy for the cost of issuing new bonds.

The shares trade at $ 20; the growth rate is 6%. Dividends paid last year - $ 1.00.

The firm has a 30% tax rate.

Kemper, Goebel & Benkato, Investment Bankers have informed you that new shares can be sold with a 10% transaction cost.

New 50 year bonds can be sold. The firm can collect:

$ 0          --             $      120000            6%

The firm added $ 180000 to retained earnings last year.

What return do the shareholders expect?

What are the weights of debt and equity in the capital structure of the firm?

Compute the WACC.

Answer 1

Soln : Here we need to calculate the return on equity, using the info. given.

So, lets say R be the cost of equity. Dividend last year = $1, growth rate = 6% and share price = $20

Share price can also be calculated using dividend growth model

20 = D/R-g or R- g = 1/20 , On calculaing thies ,we get R = 5 + 6 = 11%

Now, we need to calculate the retunr on debt by evaluating the yield to maturity, r for the bond by using this:

Bond price = Cash Flow *(1-(1/(1+r)⁴⁰))/r +100 *(1/1+r)⁴⁰  

Using hit and trial in excel , we can get the value of r = 5.42%

Now, weight of debt, w_d = 60000/240000 = 25% and w_e = 75%

WACC = w_d *(1-tax rate)* r + w_e *R = 0.25*5.42*(!-0.3) + 0.75*11 = 9.20% (approx.)

WACC = 9.20 % approx.