Question

No maximum/minimum word count. But the calculations should be shortly explained. Font: Arial 12,5 pts. Text alignment: Justified. The in-text References and the Bibliography have to be in Harvard’s citation style It assesses the following learning outcomes: Demonstrate a deep understanding of the theory and practices of financing a firm and its capital structure. Discuss and analyze the benefits of leasing versus the ownership of assets. Analyze the concepts underlying the WACC Critically evaluate dividend policy

Problem 3 (25 points) The total book value of WTC’s equity is $10 million, and book value per share is $20. The stock has a market-to-book ratio of 1.5, and the cost of equity is 15%. The firm’s bonds have a face value of $5 million and sell at a price of 110% of face value. The yield to maturity on the bonds is 9%, and the firm’s tax rate is 40%. Find the company’s WACC.

Answer 1

Book value of equity =$10 million

Book value per share = $20

Book value per share (BVPS) = Total Equity Shareholder's Fund / Total number of equity share

20 = 10 / total number of equity share

Total number of equity share = 0.5 million = 500,000

Market to book ratio = 1.5

1.5 = Market capitalization / total book value

1.5 = (Market price per share * no.of shares) / (BVPS * no. of shares)

1.5 = Market price per share / 20

30 = Market price per share

Cost of equity (Ke) = 15%

Bonds ( Face value ) = $ 5 million

Bonds ( Market Value ) = 110% of $ 5 million = $ 5.5 million

Yield to maturity on bonds (Kd) = 9%

Tax rate = 40%

WACC = Weight of Equity * Ke + Weight of debt * Kd (1-tax rate )

We take market values to compute weights

Market value of equity = 500,000 * 30 = $ 15,000,000

Market value of bonds = $ 5,500,000

Total of capital structure = $ 5,500,000 + $ 15,000,000 = 20,500,000

Weight of equity =   $ 15,000,000 / 20,500,000 = 0.7317

Weight of debt = $ 5,500,000 / 20,500,000 = 0.2683

WACC = 0.7317 * 0.15 + 0.2683 * 0.09 (1-40%) = 0.1242432 = 12.42%

(I hope it's clear. If not please comment. I will reply in the comments)

( Do you want the answer to theory questions also ? if yes please let me know in the comments)

Analyze the concepts underlying the WACC

WACC reflects the capital structure employed in the business and the costs associated with different sources of finances i.e. common equity, preference stock , debt, bonds, retained earnings, etc. It's the average rate at which finances are raised by any business. This rate represents the minimum rate of earning on the capital raised.

Critically evaluate dividend policy

There are 2 models governing dividend policy. First is the theory of relevance i.e. Relevance theory - According to this theory dividend plays an important role to determine the market price of the company i.e Gordon Model/ Growth Model , Walter's model.

Second Irrelevance theory - According to this theory, dividend do not play any role in determining the market price of the company i.e. Market price is not affected by dividend. Example - Modigliani miller model.

Discuss and analyze the benefits of leasing versus the ownership of assets

In case the asset is leased, lessor has to incur the lease rent, no depreciation can be charged, not entitled to salvage value, no interest on loan to be paid and no repayment of principal amount.

In case decides to purchase the asset by using own capital, purchaser entitled to claim depreciation and associated tax savings and the salvage value. No lease rentals to be incurred.

And in case decides to borrow capital to purchase the asset, will have to incur interest cost and also claim the associated tax savings but will have to also repay the principle amount.

The person should evaluate the present value of cash outflow (PVCO ) and the option with least PVCO should be selected.