Question

You are a conservative investor who is considering investing in “Kite Films”, a small film company. You like the intrinsic valuation approach and want to calculate Kite Films’ weighted average cost of capital and then perform a discounted cash flow analysis. You note that the equity market risk premium calculated using the geometric mean is 3.9% and the equity market risk premium calculated using the arithmetic mean is 5.8%. The risk free rate is 2.5% and the tax rate is 35%. You feel that Kite Films is riskier than the CAPM would indicate due to its small size and believe it has a size risk premium of 1.2%. You have the following information about Kite Films:  Bonds: Kite Films has two bonds as outlined below: o Bond One: six year maturity, $1,000 face value semi-annual coupon bond with a coupon of 1.73% and a yield to maturity of 4.23%. Kite Films has 25,637 of these bonds outstanding. o Bond Two: is a coupon bond that pays annually and has nine years to maturity. The coupon rate is 2.75%, its yield to maturity is 4.78% and its face value of $1,000. Kite Films has 7,864 of these bonds outstanding.  Equity: Kite Films has 4,125,876 common shares outstanding and its stock price is $3.56. Kite Films’ beta is 3.1 and its Shareholder’s Equity from the balance sheet is $9.3mm.  Unlevered Free Cash Flow as per the following table: a) Calculate Kite Films’ weighted average cost of capital. Please show all your work and round to at least 2 decimal points.

Answer 1

Cost of Equity = Risk free rate + Size premium + Beta * Market risk premium (arithmetic mean)

= 2.5%+ 1.2% + 3.1 * 5.8%

Cost of Equity = 21.7%

Market capitalization = number of shares * price per share = 4,125,876 * 3.56 = $14,688,119

Bond 1 :

Maturity= 6 year, Face value =1000, Coupon = 1.73%, Semiannual coupon = $8.65, number of coupon period = 12

Yield = 4.23%

Market value = =-PV(4.23%/2,12,8.65,1000) =$868.74

Bond 2:

Maturity= 9 year, Face value =1000, Coupon = 2.75%, Annual coupon = $27.5, number of coupon period = 9

Yield = 4.78%

Market value = -PV(4.78%,9,27.5,1000) =$854.29

Total Market value of these 2 bonds = 868.74 * 25,637 + 854.29 * 7,864 = $28,990,024

Cost debt = (1.73% * 25,637 + 2.75% * 7,864) / (25,637+7,864) = 1.969%

WACC = (21.7% * 14,688,119 + 1.969% * (1-35%) * 28,990,024) / (14,688,119 + 28,990,024)

WACC = 8.15%