Question

In period 0, Goldencat, a London-based corporation, has the following capital structure:

• The corporation has 100,000 shares of common stocks outstanding, whose price fluctuates around Pcs,0 = 10 pounds per share. In that period, the company paid out dividend of D0 = 1 per share. The financial market expects the dividend to grow in the future at a rate of g = 5% per year.

• The company’s bond-holders, mostly bankers in Brussels, have also provided the company a long-term non-amortized loan worth 3 million pounds in period 0, and they are expecting a return (YTM) of 8%. Corporate tax rate is τ = 25%.

• Goldencat also sold 50,000 preferred shares in the past to another company named RoseCo in order to raise capital to deal with previous crises. The fair market price of those preferred shares are estimated to be around Pps,0 = 20 pounds per share in period 0. The terms of the preferred shares are such that every year RoseCo receives a fixed dividend of $3 dollars per preferred share.

Answer the following question:

1. Use a “champagne tower” to model the Goldencat’s capital structure, indicating the relative position of common stocks, debt and preferred stocks.

2. Compute the relative weights of each type of capital, denoted them as wcs, wps, and wd. (Recall that wcs + wps + wd = 1.)

3. From Goldencat’s point of view, compute the cost of its common stock (kcs), the cost of its preferred stocks (kps) and the cost of its debt (kd).

4. What’s the company’s weighted average cost of capital (WACC) in period 0? (Denote it as WACC0)

5. In period 1, after debt payments and dividend payments are made to the investors, news breaks out that Goldencat has raised another 1,000,000 pounds of capital via bond issuance, and uses the proceeds of which to buy back all the preferred shares previously held by RoseCo. After this preferred shares buy-back, Goldencat only has debt and common stocks in its capital structure. The financial market does not react favorably to the news, as the price of its common stock fell to Pcs,1 = 6.5 pounds per share in period 1.

(a) Provide some intuitions on the reason behind the fall of Goldencat’s common stock price between period 0 and period 1.

(b) Compute Goldencat’s WACC in period 1 (denote it as WACC1) under the following assumptions:

i. The corporation is still committing to the dividend growth rate of g = 8% and is expected to pay out in period 2 a dividend of D2 = D1 · (1 + g) = D0 · (1 + g) 2 = 1 × (1 + 0.08)2 = 1.1664 pounds per share.

ii. Goldencat’s bond investor are still expecting a return (YTM) of 8% in period 1. Corporate tax rate remains the same at τ = 25%. The market value of Goldencat’s debt is now 3,000,000 + 1,000,000 = 4,000,000 pounds

Answer 1