Examine the following book-value balance sheet for University Products Inc. The

Question

Examine the following book-value balance sheet for University Products Inc. The preferred stock currently sells for $30 per share and pays a dividend of $3 a share. The common stock sells for $16 per share and has a beta of .7. There are 1 million common shares outstanding. The market risk premium is 8%, the risk-free rate is 4%, and the firm’s tax rate is 40%. BOOK-VALUE BALANCE SHEET (Figures in $ millions) Assets Liabilities and Net Worth Cash and short-term securities $ 2.0 Bonds, coupon = 6%, paid annually (maturity = 10 years, current yield to maturity = 7%) $ 10.0 Accounts receivable 5.0 Preferred stock (par value $10 per share) 3.0 Inventories 9.0 Common stock (par value $.10) .1 Plant and equipment 22.0 Additional paid-in stockholders’ equity 8.9 Retained earnings 16.0 Total $ 38.0 Total $ 38.0

a. What is the market debt-to-value ratio of the firm? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.) Market debt ratio %

b. What is University’s WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.) WACC %

Explanation / Answer

A. Market to debt ratio is given as (Total liability)/(Market Value of Equity + Total liability)

Total Liability = $10 Million = 10,000,000

Market Value of equity = 16 * 1 Million Shares = 16*1000000 = 16,000,000

Hence Market/dent ratio = 10/(10+16) = 0.38

B. WACC

Cost of equity (Ke)as per CAPM = Rf + beta * Rm = 4 +0.7 * 8 = 9.6% = 0.096

Cost of debt = Kd = 7% * (1- tax rate) = 0.07(1-0.4) = 0.042

Cost of preferred Stock = Kp= Dividend/ Current Price = 3/30 =10% =0.10

Total Equity = 16 Million, debt = 10 Million and Preferred Shares = 3 Million. So total capital = $29 Million

Weight of equity=We = 16/29 0.5517

Weight of debt =Wd= 10/29 = 0.3448

Weight of preferred Stock = Wp= 0.1035

hence WACC = We*ke + wd*kd + wp*kp

WACC = 0.096*0.5517 + 0.042*0.3448 + 0.1035*0.1 = 0.7779

Hene WACC = 7.78%

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