Peace Waterfront Ltd currently has 1.2 million ordinary shares outstanding and the share has a beta of 2.2. It also has $10 million face value of bonds that have 5 years remaining to maturity and 8% coupon rate with semi-annual payments, and are priced to yield 13.65%. If Peace Waterfront issues up to $2.5 million of new bonds, the bonds will be priced at par and have a yield of 13.65%; if it issues bonds beyond $2.5 million, the expected yield on the entire issuance will be 16%. Peace Waterfront has learned that it can issue new ordinary shares at $10 a share. The current risk-free rate of interest is 3% and the expected market return is 10%. Peace Waterfront’s marginal tax rate is 30%. Compute the market value for both bond and equity.
If Peace Waterfront intends to raise $7.5 million of new capital while maintaining the same debt-to-equity ratio as above, compute its weighted average cost of capital (WACC).
Can Peace Waterfront use the WACC computed for all of its future investment projects? Why?
Market value of equity = no of shares * price per share = 1.2 * 10=12 million
market value of bond = coupons * [ 1 - ( 1 + semiannual yield )^- no of periods ] / semiannual yield + face value / ( 1+ semiannual yield)^no of periods
= 0.4*[ 1 - 1.06825^-10] / 0.06825 + 10/ 1.06825^10
= 8 million
cost of equity = risk free rate + ( market return - risk free rate )* beta = 3 + ( 10-3)*2.2 = 18.4%
debt equity ratio = 8/12 = 0.67
amount required = 7.5 million
debt in 7.5 million = 7.5*0.4 = 3 million
equity in 7.5 million = 7-3 = 4.5 million
yield on bond = 16% as the issuance is more than 2.5 million
wacc = weight of debt * ( 1 - tax rate )*cost of debt + weight of equity * cost of equity
= 16*0.4*(1-0.3) + 18.4*0.6
= 4.48 + 11.04 =15.52
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