Examine the following book-value balance sheet for University Products, Inc. The

Question

Examine the following book-value balance sheet for University Products, Inc. The preferred stock currently sells for $10 per share and the common stock for $20 per share.

BOOK VALUE BALANCE SHEET
(all values in millions)   Assets    Liabilities and Net Worth   Cash and short-term securities $ 2.0       Bonds, coupon = 5%, paid annually
    (maturity = 10 years, current yield to
     maturity = 6%) $ 10.0   Accounts receivable 6.0       Preferred stock (par value $10 per
     share) 2.0   Inventories 10.0       Common stock (par value $0.2) 0.1   Plant and equipment 23.0       Additional paid-in stockholders

Explanation / Answer

Step 1:

1) Cost of Common Stock = Rf + (Rm-Rf)*Beta

Cost of Common Stock = 3 + 7*0.5

Cost of Common Stock = 6.50%

2) Cost of Preferred Stock = 1/10

Cost of Preferred Stock = 10%

3)

After Tax Cost of Debt = 6*(1-20%)

After Tax Cost of Debt = 4.80%

Step 2:

Market Value of Common Stock = 0.1/0.2Milion * 20 = $ 10 Million

Market value of Preferred Stock = 2 Miillion * 10/10 = $ 2 Million

Bond current price = pv(rate,nper,pmt,fv)

Bond current price = pv(6%,10,50,1000)

Bond current price = 926.40

No of Bond issued = 10/1000 = 0.01 Million

Market Value of Bond = 926.40*0.01 Million = 9.264 Million

Total Market Value = 10 + 2 + 9.264 = $ 21.264 Million

Weight of Common Stock = 10/21.264

Weight of Preferred Stock = 2/21.264

Weight of Debt = 9.264/21.264

Step3:

WACC = Weight of Common Stock* Cost of Common Stock + Weight of Preferred Stock* Cost of Preferred Stock + Weight of Debt* After Tax cost of Debt

WACC = 10/21.264 * 6.5 + 2/21.264 * 10 + 9.264/21.264 * 4.80

WACC = 6.09%

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