Question

6) You are the finance manager of Trutone Corp. A bond with a face value of $1000 is convertible to common stock at a conversion ratio of 60. The stock is currently trading at $8.20 per share.

a)   If you call the bonds, will the bondholders convert into shares or accept the call price? Explain.

b)   What price must the stock surpass in order for the bondholders to convert?

8) A firm requires an investment of $30,000 and borrows $10,000 at 6%. If the return on equity is 15%, what is the firm's pre tax WACC?

9) A firm undertakes an investment that is financed with $10,000 of equity and $30,000 of debt. If the return on equity is 14%, the cost of debt is 7% and the tax rate is 25%, what is the firm's WACC?

12) Rogot Corp. has a market debt-equity ratio of .6 and a corporate tax rate of 35%, and pays 8% interest on its debt. By what amount does the interest tax shield from its debt lower Rogot’s WACC? Show your work.

Answer 1

6) Face value of 1 bond = $1,000

Number of shares to be received on conversion of 1 bond = 60

Current price of shares = $8.2 per share

Value of 60 shares = 60 * 8.2 = $492

a) If the bonds are called the bondholders will not convert their bonds to shares because value of 60 shares is only $492, while bond is worth $1,000.

b) Stock must surpass the price of $16.66 in order for the bondholders to convert. Calculation is as under-

Value of bond = $1,000

Number of shares to be received on conversion of 1 bond = 60

Price to surpass in order for the bondholders to convert = 1,000/60 = $16.66

8) Pre tax WACC = 12%

Required funds = $30,000

Borrowed funds (D) = $10,000

Balance funds shall be raised in form of equity (E) = $20,000

Cost of debt (K_d) = 6%

Cost of equity (K_e) = 15%

Pre tax WACC = D/(D+E) * K_d + E/(D+E) * K_e = 10,000/(10,000+20,000) * 6 + 20,000/(10,000+20,000) * 15 = 12%

9) WACC = 7.44%. WACC is calculated after tax.

Debt (D) = $30,000

Equity (E) = $10,000

Cost of debt (K_d) = 7%

After tax cost of debt (K_da) = 7(1-0.25) = 5.25%

Cost of equity (K_e) = 14%

WACC = D/(D+E) * K_da + E/(D+E) * K_e = 30,000/(30,000+10,000) * 5.25 + 10,000/(30,000+10,000) * 14 = 7.44%

12) WACC reduced due to interest tax shield is 1.05%

Debt-Equity ratio = 0.6

Hence, Debt = 0.6 and Equity = 1

Corporate tax rate = 35%

Cost of debt (K_d) = 8%

After tax cost of debt (K_da) = 8(1-0.35) = 5.2%

Assuming cost of equity (K_e) to be 10%, since cost of equity is not provided in the question.

Pre tax WACC = D/(D+E) * K_d + E/(D+E) * K_e = 0.6/(0.6+1) * 8 + 1/(0.6+1) * 10 = 9.25%

WACC = D/(D+E) * K_da + E/(D+E) * K_e = 0.6/(0.6+1) * 5.2 + 1/(0.6+1) * 10 = 8.20%

Reduction in WACC due to tax shield = 9.25% - 8.20% = 1.05%