Common stocks of the Threes Company which currently has no debt in its capital s
ID: 2689304 • Letter: C
Question
Common stocks of the Threes Company which currently has no debt in its capital structure are trading for $50 a share. Threes has 2 million shares outstanding now. Threes Co. uses the CAPM in estimating costs of capital. The (unlevered) equity beta for Threes Co. is 1.25, and the risk-free rate and the market portfolio return are expected to be 5% and 13%, respectively. Its income tax rate is 35%. Mr. Jack Tripper, the Vice-President of Finance, is considering changing its financing policy to actively maintain a target debt ratio of 20% (or 25% debt-to-equity ratio) of the levered firm. An investment bank informed him that Threes may be able to issue 10-year $1,000 par bonds for $922.05 per bond if it offers 4.0% annual coupon, or for $1,116.92 per bond if it offers 6.5% annual coupons. Coupons will be paid semi-annually. Threes plans to keep refinancing bonds at maturity to effectively make bonds perpetual. Compute: i) cost of equity at the target leverage ratio, ii) cost of debt, and iii) the WACC of the Threes Co.Explanation / Answer
a)
Levered beta = Unlevered beta*[1+(1-tax rate)*Debt/Equity]
Unlevered beta
1.25
tax rate
35%
Debt/equity
25%
Unlevered beta
1.45
Risk free rate of return
5%
Market return
13%
As per CAPM,
Cost of equity
16.63%
b)
Option 1
Option 2
Par value
1000
1000
Issue price
922.05
1116.92
Coupon rate
4%
6.50%
Coupon paid
20
32.5
No. of periods
20
20
Tax rate
35%
35%
Effective cost of debt
1.76%
1.44%
Annual cost of debt
3.55%
2.91%
Thus, the bond chosen will be option 2
Cost of debt
2.91%
c)
Equity
Debt
Cost
16.63%
2.91%
Weight
80%
20%
WACC
13.88%
Levered beta = Unlevered beta*[1+(1-tax rate)*Debt/Equity]
Unlevered beta
1.25
tax rate
35%
Debt/equity
25%
Unlevered beta
1.45
Risk free rate of return
5%
Market return
13%
As per CAPM,
Cost of equity
16.63%
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