LDavola, Inc. has a target capital structure of 50% debt and 50% common equity.

Question

LDavola, Inc. has a target capital structure of 50% debt and 50% common equity. Raya, funds debt by issuing 20- year, 6.4% semi-annual coupon bonds that currently sell for $925. The risk-free rate (tw) is 496, Davoaabeta is 1.5 and their estimated market risk premium is 7%. Dovolaa tax rate is 40% a. What is Daxola's after-tax, component cost of debt? b. What is Dayola's component cost of equity? c. What is Daxola'sWACC? 2.Pitt Products Company (PPC) has a target capital structure that consists of 40% debt and 60% common equity. PPC can borrow unlimited amounts of capital at an interest rate of 9.75% as long as the target capital structure is maintained. PPC's last dividend paid was $2.05, its expected constant growth rate is 5%, and its stock sells for $24 PPC's tax rate is 40% PPC is currently evaluating four projects Project A with a cost of $240 million and a rate of return of 13%, Project B with a cost of $125 million and a rate of return of 12%. Project C with a cost of $200 million and a rate of return of 11% and Project D with a cost of $150 million and a rate of return of 10% . . Assume that all four projects are independent; however, Project A has been judged a very risky project, while Projects C and D have been judged as low-risk projects. Project B remains an average-risk project. If PPC adjusts its WACC by adding 2 percentage points for high-risk projects and subtracting 2% for low-risk projects, what is their optimal capital budget (in millions)? Hint: Find the WACC for PPC first. 3. Benes Inc. has the following financial information: . Debt: The firm issued 1,000, 20 year bonds five years ago which were sold at a par value of S1,000. The bonds carry a coupon rate of 7.8% Preferred Stock: Pays an 8.9% preferred dividend with a par of $100 and is currently selling for $82 Equity: Benes, common stock currently sells for $35 and grows at a constant rate of 5%. Benes will pay a $2.25 dividend to their shareholders. Benes' business plan for next year projects net income of $540,000, half of which will be retained The company applies an average tax rate of 35% for cost of capital decision-making purposes Benes Inc. pays flotation costs of 10% on all new stock issues Benes' capital structure is 40% debt, 10% preferred stock and 50% common equity. . · . . . a. Compute the capital component costs for each of the capital components (debt, preferred stock and equity using retained earnings). Ignore flotation costs for debt and preferred stock. b. Calculate the WACC before the break in retained earnings c. Calculate Davola's break point in retained earnings. d. Calculate the WACC after the break in retained earnings. In other words, calculate the WACC given the point that the firm will have to issue new stock to fund the equity portion of its capital budget.

Explanation / Answer

Answer to Question 1:

Debt:

Face Value = $1,000
Current Price = $925

Annual Coupon Rate = 6.4%
Semiannual Coupon Rate = 3.20%
Semiannual Coupon = 3.20%*$1,000 = $32

Time to Maturity = 20 years
Semiannual Period to Maturity = 40

Let semiannual YTM be i%

$925 = $32 * PVIFA(i%, 40) + $1,000 * PVIF(i%, 40)

Using financial calculator:
N = 40
PV = -925
PMT = 32
FV = 1000

I = 3.554%

Semiannual YTM = 3.554%
Annual YTM = 2 * 3.554%
Annual YTM = 7.108%

Before-tax Cost of Debt = 7.108%
After-tax Cost of Debt = 7.108% * (1 - 0.40)
After-tax Cost of Debt = 4.26%

Equity:

Cost of Common Equity = Risk-free Rate + Beta * Market Risk Premium
Cost of Common Equity = 4% + 1.5 * 7%
Cost of Common Equity = 14.50%

WACC = Weight of Debt*After-tax Cost of Debt + Weight of Common Stock*Cost of Common Stock
WACC = 50% * 4.26% + 50% * 14.50%
WACC = 9.38%

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