Erna Corp. has 4 million shares of common stock outstanding. The current share p

Question

Erna Corp. has 4 million shares of common stock outstanding. The current share price is $70, and the book value per share is $5. Erna Corp. also has two bond issues outstanding. The first bond issue has a face value of $60 million, has a coupon rate of 5 percent, and sells for 95 percent of par. The second issue has a face value of $40 million, has a coupon rate of 6 percent, and sells for 104 percent of par. The first issue matures in 20 years, the second in 4 years.

Suppose the most recent dividend was $4.20 and the dividend growth rate is 4 percent. Assume that the overall cost of debt is the weighted average of that implied by the two outstanding debt issues. Both bonds make semiannual payments. The tax rate is 38 percent. What is the company

Erna Corp. has 4 million shares of common stock outstanding. The current share price is $70, and the book value per share is $5. Erna Corp. also has two bond issues outstanding. The first bond issue has a face value of $60 million, has a coupon rate of 5 percent, and sells for 95 percent of par. The second issue has a face value of $40 million, has a coupon rate of 6 percent, and sells for 104 percent of par. The first issue matures in 20 years, the second in 4 years.

Suppose the most recent dividend was $4.20 and the dividend growth rate is 4 percent. Assume that the overall cost of debt is the weighted average of that implied by the two outstanding debt issues. Both bonds make semiannual payments. The tax rate is 38 percent. What is the company

Explanation / Answer

Step1: Computation of Cost of Equity.We have,

Market price of share = D0 (1+g )/ Ke - g

Where,

D0 = dividend = $ 4.20

g = Growth rate = 4%

Ke = Cost of Equity

70.00 = 4.20 X 1.04 / Ke -0.04

Ke -0.04 = 0.0624

Ke = 0.0624 + 0.04 = 0.1024 = 10.24 %

Hence, Cost of Equity = 10.24%

Step2: Computation of Cost of Debt.We have,

For First issue bond,

Cost of Bond = (1.025)40 x (1- .38) / 95 = 1.75 %

Hence, Cost of bond is 1.75%.

For Second issue bond,

Cost of Bond = (1.03)8 x ( 1 - 0.38 ) / 104 = 0.76%

Cost of Bond is 0.76 %

Step3: Computation of company's WACC.We have,

Book value of share = 4 x 5 =$ 20,000,000

Value of First issue bond = $ 60,000,000

Value of second issue bond = $ 40,000,000

Total Value = 1,200,000,000

The WACC = (20/1,200) X 10.24 + (60/1,200) X 1.75 + (40/1,200) X 0.76

The WACC = 0.1710 + 0.0875 + 0.0253 = 0.2838

Hence, the WACC of Erna Corp. is 0.2838.

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