10-16 Market Value Capital Structure : Suppose the Schoof Company has this book

Question

10-16 Market Value Capital Structure: Suppose the Schoof Company has this book value balance sheet:

Current assets $30,000,000            Current Liabilities   $10,000,000

Fixed assets      50,000,000             Long-term debt 30,000,000

                                             Common stock

(1 million shares)   1,000,000

                    __________            Retained earnings 39,000,000

Total assets     $80,000,000     Total liabilities and equity    $80,000,000

The current liabilities consist entirely of notes payable to banks, and the interest rate on this debt is 10%, the same as the rate on new bank loans. These bank loans are not used for seasonal financing but instead are part of the companys permanent capital structure. The long-term debt consists of the companys permanent capital structure. The long-term debt consists of 30,000 bonds, each with a par value of $1,000, an annual coupon interest rate of 6%, and a 20-year maturity. The going rate of interest on new long-term debt, rd, is 10%, and this is the present yield to maturity on the bonds. The common stock sells at a price of $60 per share. Calculate the firms market value capital structure. You must convert the components into current market value in order to compute the capital structure. Explain why this adjustment is needed.

Explanation / Answer

Market value of equity = no of shares * price/share = 1,000,000 * 60 = $60,000,000

Price of bonds can be calculated in Excel as =PV(10%,20,-60,-1000). This is equal to 659.46. So total market value of bonds = 30,000 bonds * price/bond = 30,000*659.46 = 19,783,724

Total market value of debt = market value of long term debt + current liabilities = 19,783,724 + 10,000,000 = 29,783,724

So total market value of firm = 60,000,000 + 29,783,724 = $89,783,724

Conversion is needed as any new capital raised to finance new activities will be at the current prices rather than the historic book value which does not have any significance now. So any subsequent calculation of WACC should consider current market value only.

Hope this helped ! Let me know in case of any queries.

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