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 $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.)

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%