Really need help !!!! 2. You are given the following information concerning Arou

Question

Really need help !!!!

2. You are given the following information concerning Around Town Tours:

· Debt: 8,500 shares, 7.1 percent coupon bonds outstanding, with 14 years to maturity and a price of $1,026. Bonds pay interest semiannually.

· Common stock: 265,000 shares selling for $76 per share; stock beta is 0.92 and will pay dividend of $2.48 next year. The dividend is expected to grow by 4 percent per year indefinitely

· Preferred stock: 7,500 shares, 6 percent dividend, selling at $88 per share.

You also know the return on market portfolio is 13.2%; risk-free rate is 4.5%; and firm tax rate is 34%.

a. What is the cost of equity using CAPM? What is cost of equity using dividend growth model? What is your estimate of the cost of equity, based on the above results?

b. What is before tax cost of debt? What is after-tax cost of debt?

c. What is cost of preferred stock?

d. What are the firms capital structure weights of equity, debt, and preferred stock?

e. Calculate the WACC for this firm.

Explanation / Answer

a. Cost of equity using CAPM = risk free rate + beta * (market return-risk free rate) = 4.5%+0.92*(13.2%-4.5%) = 12.50%

Cost of equity using dividend growth model = next year dividend / stock price + growth rate = 2.48/76 + 4% = 7.26%

So estimated cost of equity = average of (12.50% and 7.26%) = 9.88%

b. Yield of bond can be calculated in Excel as =RATE(14*2,-1000*7.1%/2,1026,-1000)*2. This is equal to 6.81%

So pre tax cost of debt = 6.81%

After tax cost of debt = pre tax cost *(1-tax rate) = 6.81%*(1-34%) = 4.49%

c. Cost of preferred stock = dividend/stock price = 6/88 = 6.82%

d. Market value of debt = 8500*1026 = 8,721,000

Market value of common stock = 265,000*76 = 20,140,000

Market value of preferred stock = 7500*88 = 660,000

Total market value = 8,721,000 + 20,140,000 + 660,000 = 29,521,000

Weight of equity = 20,140,000 / 29,521,000 = 68.22%

Weight of debt = 8,721,000 / 29,521,000 = 29.54%

Weight of preferred stock = 660,000 / 29,521,000 = 2.24%

e. WACC = weight of equity*cost of equity + weight of debt*after tax cost of debt + weight of preferred stock*cost of preferred stock = 68.22%*9.88% + 29.54%*4.49% + 2.24%*6.82% = 8.22%

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

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