Junior Interiors market value capital structure of 62% Common Equity, 3% Preferr
ID: 2709998 • Letter: J
Question
Junior Interiors market value capital structure of 62% Common Equity, 3% Preferred Stock (PS) and 35% Debt. The company does not pay dividends, and evaluates its operations as approximately 30% more risky than an “average” company in the industry. The overall rate of return on average industry investments is 8.4% and risk-free investments currently return 1.7%.
Company Bonds sell for 97% of $2,000,000 Face value; carry a 6% annual interest rate with interest only payments made monthly. Currently outstanding debt obligations are due in 4 years. The firm’s PS has a current annual yield of 7.1%. It applicable tax rate is 32%.
What is Juniors Weighted Average Cost of Capital (WACC)?
If the regular PS dividend is $1.35 per quarter, for what does the stock currently sell?
A firm has a target Debt to Equity ratio of .85. It WACC is 10.2% and the applicable tax rate is 35%. If the company Cost of Equity is 13.4%, what is its PRE-TAX Cost of Debt?
Stock B has a Beta of 1.1 and an expected return of 12.3%. If the risk-free rate is 3.7% and MRP is 7%, is Stock B priced correctly?
(Need all answers with steps and reasoning)
Explanation / Answer
Junior Interiors market value capital structure of 62% Common Equity, 3% Preferred Stock (PS) and 35% Debt. The company does not pay dividends, and evaluates its operations as approximately 30% more risky than an “average” company in the industry. The overall rate of return on average industry investments is 8.4% and risk-free investments currently return 1.7%.
Company Bonds sell for 97% of $2,000,000 Face value; carry a 6% annual interest rate with interest only payments made monthly. Currently outstanding debt obligations are due in 4 years. The firm’s PS has a current annual yield of 7.1%. It applicable tax rate is 32%.
What is Juniors Weighted Average Cost of Capital (WACC)?
Step 1:
1) Beta = (1+ 30%*1) = 1.30
Cost of Common Stock = Rf + (Rm-Rf)*Beta
Cost of Common Stock = 1.7 + (8.4-1.7)*1.3
Cost of Common Stock = 10.41%
2)
Cost of Preferred Stock = 7.1%
3) Monthly Interest Rate = rate(nper,pmt,pv,fv)
nper =4*12 = 48
pmt = 6%*2000000*1/12 =10000
pv = 97%*2000000 = 1940000
fv = 2000000
Monthly Interest Rate = rate(48,10000,-1940000,2000000)
Monthly Interest Rate= 0.5716 %
Effective annual interest rate = (1+0.5716%)^12 - 1
Effective annual interest rate = 7.08%
After Tax Cost of Debt = Effective annual interest rate *(1-tax rate)
After Tax Cost of Debt = 7.08*(1-32%)
After Tax Cost of Debt = 4.81%
Step 2:
Weight of Common Stock = 3%
Weight of Preferred Stock = 32%
Weight of Debt = 65%
Step3:
WACC = Weight of Common Stock* Cost of Common Stock + Weight of Preferred Stock* Cost of Preferred Stock + Weight of Debt* After Tax cost of Debt
WACC = 3%*10.41 + 32%*7.1 + 65%*4.81
WACC = 5.71%
If the regular PS dividend is $1.35 per quarter, for what does the stock currently sell?
stock currently sell = 1.35*4/7.1%
stock currently sell = $ 76.06
A firm has a target Debt to Equity ratio of .85. It WACC is 10.2% and the applicable tax rate is 35%. If the company Cost of Equity is 13.4%, what is its PRE-TAX Cost of Debt?
PRE-TAX Cost of Debt =(( WACC - Cost of Equity*1/(1+Debt to Equity ratio))* (1+Debt to Equity ratio)/Debt to Equity ratio )/(1-tax rate)
PRE-TAX Cost of Debt =( (10.2%-13.4%*1/(1+0.85))*(1+0.85)/0.85 )/(1-35%)
PRE-TAX Cost of Debt = 9.90%
Stock B has a Beta of 1.1 and an expected return of 12.3%. If the risk-free rate is 3.7% and MRP is 7%, is Stock B priced correctly?
As per CAPM
Required rate of return = risk-free rate + MRP*beta
Required rate of return = 3.7 + 7*1.1
Required rate of return = 11.40%
Stock B is not priced correctly as its Required rate of return is lower than Expected return than the stock B Price is underpriced
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.