A summary of the balance sheet of Travellers Inn Inc. (TII), a company which was

Question

A summary of the balance sheet of Travellers Inn Inc. (TII), a company which was formed by merging a number of regional motel chains and which hopes to rival Holiday Inn on the national scene, is as follows:

Travellers Inn Inc.

Balance Sheet

December 31, 2012 (Millions of Dollars)

Cash $ 10 Accounts payable $ 10

Accounts receivable 20 Accruals 10

Inventories 20 Short-term debt 10

Current Assets $ 50 Current liabilities $ 30

Net fixed assets 50 Long-term debt 30

Common stock 10

Retained earnings 30

Total assets $100 Total liabilities & equity $100

Consider the following facts for TII:

(1) Short-term bank debt currently costs 6 percent and it is used to finance receivables and inventories on a seasonal or temporary basis.

(2) Long-term debt consists of 20-year, semiannual payment mortgage bonds, each with a face value of $1,000 and an annual coupon rate of 8 percent. Currently, these bonds provide investors a yield-to-maturity of 9 percent.

(3) The company has 4 million shares of common stock outstanding at a current market price of $15 per share. Its equity beta is 1.5, the Treasury bond rate is 3 percent and the market risk premium is 7 percent.

(4) TII is in the 40 percent federal-plus state marginal tax bracket.

Estimate the company’s weighted average cost of capital (WACC) using market value capital structure weights.

Explanation / Answer

Cost of Equity = 3 + 1.5*(7-3) = 3+ 6 = 9% ; Cost of Debt (long term) = 9% *(1 - tax rate) = 9*0.6 = 5.4% ; Cost of Debt (short term) = 6%(1- tax rate) = 3.6% ; WACC = cost of Debt*weight of debt + cost of equity * weight of equity = 3.6*0.2 + 5.4*0.5 + 9*0.3 = 6.12 % PV of a bond = 80/(1.045) + 80/1.045^2 + 80/1.045^3 + .......80/1.045^40 + 1000/1.045^40 = $1754.89

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