Question

You are given the following information concerning Parrothead Enterprises: Debt: 10,000 6.9% coupon bonds outstanding, with 15 years to maturity currently selling for 104 percent of par. These bonds pay interest semiannually. (YTM is 6.48%) Common Stock: 275,000 shares of common stock selling for $68.50 per share. The stock has a beta of .85 and will pay a dividend of $3.25 next year. The dividend is expected to grow by 5 percent per year indefinitely. Preferred Stock: 8,000 shares of preferred stock selling at $94 per share paying a dividend of $4.90. Market: 12 percent expected return, risk-free rate of 3.5 percent, and a 35 percent tax rate. a. What is the firm’s market value capital structure? b. What is the firm’s cost of equity? c. What is the firm’s cost of debt? d. What is the firm’s cost of preferred stock? e. What is the firm’s weight average cost of capital?

Answer 1

a

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

MV of equity=68.5*275000

=18837500

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

MV of Bond=1000*10000*1.04

=10400000

MV of Preferred equity=Price*number of shares outstanding

MV of Preferred equity=94*8000

=752000

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

=18837500+10400000+752000

=29989500

Weight of equity = MV of Equity/MV of firm

Weight of equity = 18837500/29989500

W(E)=0.6281

Weight of debt = MV of Bond/MV of firm

Weight of debt = 10400000/29989500

W(D)=0.3468

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

Weight of preferred equity = 752000/29989500

W(PE)=0.0251

b

As per CAPM

expected return = risk-free rate + beta * (expected return on the market - risk-free rate)

Expected return% = 3.5 + 0.85 * (12 - 3.5)

Expected return% = 10.73

Price = Dividend in 1 year/(cost of equity - growth rate)

68.5 = 3.25/ (Cost of equity - 0.05)

Cost of equity% = 9.74

cost of equity = (10.73+9.74)/2 = 10.24%

c

Cost of debt

K = Nx2

Bond Price =∑ [(Semi Annual Coupon)/(1 + YTM/2)^k]     +   Par value/(1 + YTM/2)^Nx2

k=1

K =15x2

1040 =∑ [(6.9*1000/200)/(1 + YTM/200)^k]     +   1000/(1 + YTM/200)^15x2

k=1

YTM = 6.48

d

cost of preferred equity

cost of preferred equity = Preferred dividend/price*100

cost of preferred equity = 4.9/(94)*100

=5.21

e

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

After tax cost of debt = 6.4791063959*(1-0.35)

= 4.21

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

WACC=4.21*0.3468+10.24*0.6281+5.21*0.0251

WACC =8.02%