Question

QUESTION 1:
XYZ Inc. has 10 million shares of common stock outstanding. The current share price is $20 per share. The most recent dividend was $1 and the dividend growth rate is 4%.
XYZ also has a bond issue outstanding, which is maturing in 15 years, has a face value of $100 million, 7% coupon payable annually, and sells for 83.8786% of the face value.
XYZ also has 2,000,000 preferred shares outstanding, which are currently selling for $40 per share and pay a dividend of $3 per year.
The Corporate tax rate is 40%.
Determine the weighted average cost of capital?

QUESTION 2:
Following are the probability distributions of annual returns of ABC Enterprises and TSX Composite Index (market).
Probability RABC RTSXComp
0.20 -5 2
0.50 11 6
0.30 14 10
a. Compute the expected annual returns, variances, and the standard deviations for ABC
and the TSX Composite Index.
b. Compute the covariance.
c. Compute the coefficient of correlation and interpret it.
d. Compute the Beta for ABC and interpret it.
e. Using CAPM determine the required rate of return for ABC if the risk free rate of
return is 4%.

QUESTION 3:
NoLev Limited an all equity firm has 1,000,000 shares of common stock outstanding at $50 per share. Janice Outperform wants to acquire a stake of 2% in NoLev but has not decided among the three possible financing choices. She can create homemade leverage by borrowing 40%, 50%, or 60% of the money she needs at a constant interest rate of 8% per year. The return on equity of NoLev is 15%. Assume an MM no tax world.
a. How much dollar return Janice expects to earn from her investment each year under each of the three financing alternatives respectively?
b. What are Janice’s returns on equity in each financing alternative respectively?
c. What are Janice’s EPS in each financing alternative respectively?
d. From parts (b) and (c), what inference can she draw about the return on equity and EPS of a leveraged firm?

QUESTION 4:
AllEquity Inc., an all equity firm has total equity of $100,000,000 and has 5 million shares outstanding. AllEquity expects to have EBIT of $15,000,000 per year in perpetuity. AllEquity is planning to issue $50,000,000 of perpetual bonds at par. The bonds will have a coupon rate of 8%. After the sale of the bonds AllEquity will maintain the new capital structure indefinitely. AllEquity’s tax rate is 40%.
a. What are AllEquity’s current value, cost of equity and the WACC?
b. What is the AllEquity’s value after the announcement of the debt issue?
c. How many shares of stock will AllEquity retire?
d. What is the AllEquity’s cost of equity and the WACC after the capital restructuring has taken place.

QUESTION 5:
ABC Manufacturing currently has no debt. Joshua Optimal, VP – Finance would like to estimate the optimal capital structure. The following data are relevant for the analysis.
EBIT = $2,000,000 per year in perpetuity Tc = 40%
Dividend Payout ratio = 100% r0 = 10% rB = 6%
Present value of bankruptcy related costs = $5,000,000
Probabilities of bankruptcy at different debt levels are as follows:
Debt Level (in millions of dollars) $0 2.5 5 7.5 10 12.5
Probability of Bankruptcy (%) 0 0 10 20 40 70
a. Determine the optimal level of debt.
b. Determine the weighted average cost of capital at the optimal debt level.

Answer 1

QUESTION 1.

Note 1 : Cost of Common stock = D(1+g)/P₀ + g

= 1(1+0.04)/20 + 0.04

= 1.04/20 + 0.04

= 0.092 or 9.2%

Note 2 : Cost of Debt using YTM formula

Approximate YTM = {C(1-T) + (F - P) / n} / ((F + P) / 2)

Where...

YTM = Yield to Maturity
C = Coupon or Interest Payment

T = Tax rate

F = Face Value
P = Price
n = Years to Maturity

Thus, YTM = { $7(1-0.40) + ($100- $83.8786)/ 15} / ($100 + $83.8786) / 2

= {4.2 + 16.1214 /15 } / 183.8786 / 2

= 4.2 + 1.07476 / 91.9393

= 5.2748/91.9393

= 0.0574 or 5.74%

Note 3 : Cost of Preferred Stock = 3 / 40 = 0.075 or 7.5%

Note 4 : Weights

	Value ( million)	Weights
Common Stock	$ 200.00	0.5496
Debt	$ 83.88	0.2305
Preferred Stock	$ 80.00	0.2199
Total	$ 363.88	1

Weighted Average cost of Capital = 9.2(0.5496) + 5.74(0.2305) + 7.5(0.2199)

= 8.03%