Question

Examine the following book-value balance sheet for University Products Inc. The preferred stock currently sells for...

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 $20 per share and has a beta of 0.7. There are 2 million common shares outstanding. The market risk premium is 10%, the risk-free rate is 6%, 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 = 7%, paid annually
(maturity = 10 years, current yield to maturity = 8%)
$ 5.0
Accounts receivable 4.0 Preferred stock (par value $10 per share) 3.0
Inventories 8.0 Common stock (par value $0.10) 0.2
Plant and equipment 24.0 Additional paid-in stockholders’ equity 17.8
   Retained earnings 11.0
Total $ 37.0 Total $ 37.0

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.)

Homework Answers

Answer #1
Component Market Value in $ million Weight
a) MV of debt at YTM of 8% = 5/1.08^10+5*7%*(1.08^10-1)/(0.08*1.08^10) = 4.66 8.69%
MV of preferred stock = (3/10)*30 = 9.00 22.50%
MV of common stock = (0.2/0.1)*20 = 40.00 74.54%
Total 53.66
Market debt to value ratio = 8.69%
b) Component cost of capital:
After tax cost of debt = 8%*(1-40%) = 4.80%
Cost of preferred stock = 3/30 = 10.00%
Cost of common equity per CAPM = 6%+0.7*10% = 13.00%
WACC:
Component Market Value in $ million Weight Component Cost WACC
MV of debt 4.66 8.69% 4.80% 0.42%
MV of preferred stock 9.00 22.50% 10.00% 2.25%
MV of common stock 40.00 74.54% 13.00% 9.69%
Total 53.66 12.36%
WACC 12.36%
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