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 $16 per share and has a beta of 0.6. There are 3 million common shares outstanding. The market risk premium is 8%, the risk-free rate is 4%, 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 = 8%, paid annually (maturity = 10 years, current yield to maturity = 9%)	$	5.0
Accounts receivable		3.0			Preferred stock (par value $10 per share)		3.0
Inventories		7.0			Common stock (par value $0.10)		0.3
Plant and equipment		25.0			Additional paid-in stockholders’ equity		16.7
					Retained earnings		11.0
Total	$	36.0			Total	$	36.0

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

K = N

%age of par =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =10

%age of par =∑ [(8*100/100)/(1 + 9/100)^k]     +   100/(1 + 9/100)^10

k=1

%age of par = 93.58%

MV of equity=Price of equity*number of shares outstanding

MV of equity=16*3000000

=48000000

MV of Bond=Par value*bonds outstanding*%age of par

MV of Bond=1000*5000*0.9358

=4679000

MV of Preferred equity=Price*number of shares outstanding

MV of Preferred equity=30*300000

=9000000

MV of firm = MV of Equity + MV of Bond+ MV of Preferred equity

=48000000+4679000+9000000

=61679000

Weight of debt = MV of Bond/MV of firm

Weight of debt = 4679000/61679000

W(D)=0.0759 = 7.59% = debt to market value of the firm

b

Weight of equity = MV of Equity/MV of firm

Weight of equity = 48000000/61679000

W(E)=0.7782

Weight of preferred equity = MV of preferred equity/MV of firm

Weight of preferred equity = 9000000/61679000

W(PE)=0.1459

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (Market risk premium)

Cost of equity% = 4 + 0.6 * (8)

Cost of equity% = 8.8

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 9*(1-0.4)

= 5.4

cost of preferred equity

cost of preferred equity = Preferred dividend/price*100

cost of preferred equity = 3/(30)*100

=10

WACC=after tax cost of debt*W(D)+cost of equity*W(E)+Cost of preferred equity*W(PE)

WACC=5.4*0.0759+8.8*0.7782+10*0.1459

WACC =8.72%