Question

Examine the following book-value balance sheet for University Products Inc. The preferred stock currently sells for $30 per share and pays a dividend of $3 a share. The common stock sells for $20 per share and has a beta of 0.7. There are 2 million common shares outstanding. The market risk premium is 10%, the risk-free rate is 6%, and the firm’s tax rate is 40%. BOOK-VALUE BALANCE SHEET (Figures in $ millions) Assets Liabilities and Net Worth Cash and short-term securities $ 1.0 Bonds, coupon = 7%, paid annually (maturity = 10 years, current yield to maturity = 8%) $ 5.0 Accounts receivable 4.0 Preferred stock (par value $10 per share) 3.0 Inventories 8.0 Common stock (par value $0.10) 0.2 Plant and equipment 24.0 Additional paid-in stockholders’ equity 17.8 Retained earnings 11.0 Total $ 37.0 Total $ 37.0

a. What is the market debt-to-value ratio of the firm? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

b. What is University’s WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Answer 1

a) Market Value of Equity = 2m x 20 = 40 million

Market Value of Preferred = 30 x 0.3m = 9 million

Market Value of Debt can be calculated using PV function

N = 10, PMT = 7% x 5 = 0.35, FV = 5, I/Y = 8% => Compute PV = $4.66 million

Total Value = $53.66 million

Market debt to value = 4.66 / 53.66 = 8.69%, Market preferred to value = 9 / 53.66 = 16.77% and equity = 74.54%

b) Cost of equity = Rf + beta x MRP = 6% + 0.7 x 10% = 13%

Cost of preferred stock = 3 / 30 = 10%

Cost of debt = 8%

WACC = 16.77% x 10% + 8.69% x 8% x (1 - 40%) + 74.54% x 13% = 11.78%