Question

5. Whitley Motors Inc. has the following capital. Debt: The firm issued 900, 25 year bonds five years ago which were sold at a par value of $1,000. The bonds carry a coupon rate of 7%, but are currently selling to yield new buyers 10%. Preferred Stock:3,500 shares of 8% preferred were sold 12 years ago at a par value of $50. They’re now priced to yield 11%. Equity: The firm got started with the sale of 10,000 shares of common stock at $100 per share. Since that time earnings of $800,000 have been retained. The stock is now selling for $89. Whitley’s business plan for next year projects net income of $300,000, half of which will be retained. The firm’s marginal tax rate is 38% including federal and state obligations. It pays flotation costs of 8% on all new stock issues. Whitely is expected to grow at a rate of 3.5% indefinitely and recently paid an annual dividend of $4.00. Develop Whitley’s WACC before and after the retained earnings break and indicate how much capital will have been raised when the break occurs. First develop the market based capital structure by valuing the capital components.

Debt: ____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

Preferred: ______________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

Equity: _______________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

The market value based capital structure is then

	Total capital contribution	Weight
Debt
Preferred Stock
Equity Capital
Total

Next develop the capital component costs.

Debt:Cost of debt = kd(1-T) = __________________________________________________________

Preferred:Cost of preferred = kp / (1-f) = _________________________________________________

Equity from RE: ke = [D0(1+g) / P0] + g = _________________________________________________

Equity from new stock: ke = [D0(1+g) / P0(1-f)] + g = __________________________________________ _____________________________________________________________________________________

WACC calculations:

Before the break

	Mix	Cost	Factor
Debt
Preferred Stock
Equity Capital
Total

After the break

	Mix	Cost	Factor
Debt
Preferred Stock
Equity Capital
Total

Calculate the break point

            Planned RE = __________________________________________________________________

            ______________________________________________________________________________

Answer 1

	Value	Weight	Cost
Debt	$670,134	39.71%	10.00%
Preferred	$127,273	7.54%	11.00%
Equity	$890,000	52.74%	8.15%
Total	$1,687,407	WACC	7.59%

Let's calculate the price of each bond using PV function on a calculator

N = 20, PMT = 7% x 1000 = 70, I/Y = 10%, FV = 1000 => Compute PV = $744.59

Value of debt = 670,134

Value of preferred = Dividend / Yield = 8% x 50 / 11% = $36.36

Total Preferred Value = 36.36 x 3,500 = 127,273

Value of equity = 10,000 x 89 = 890,000

Total = 1,687,407

Weight = Value / Total

After-tax cost of debt = 10% x (1 - 38%) = 6.2%

Cost of preferred = 11%

Cost of retained earnings = D0 x (1 + g) / P + g = 4 x (1 + 3.5%) / 89 + 3.5% = 8.15%

=> WACC = 39.71% x 6.2% + 7.54% x 11% + 52.74% x 8.15% = 7.59%