Question

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?

Answer 1

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