The Balance Sheet (book values) for Atlantic Enterprises is provided below. Bala
ID: 2742230 • Letter: T
Question
The Balance Sheet (book values) for Atlantic Enterprises is provided below. Balance Sheet of Atlantic Enterprises Current Assets 1,634,000.00 Debt 3,000,000.00 Fixed Assets 6,536,000.00 Preferred Equity 1,300,000.00 Common Equity 3,870,000.00 8,170,000.00 8,170,000.00 In addition, you are provided with the following additional information. Assume that the corporate tax rate is 40 percent. Debt: 3,000 bonds at a coupon rate of 7 percent are outstanding, $1,000 par/face value, 20 years to maturity, selling for 104 percent of par; the bonds make semi-annual payments. Preferred Stock: 13,000 shares of 8 percent preferred stock are outstanding, with a $100 par value and currently selling for $105 per share. Common Stock: 90,000 shares outstanding, selling for $53 per share; the beta is 1.2; the most recent dividends received by the common shareholders was $4.00 per share. This dividend is expected to grow at a constant rate of 7 percent forever. Market: 8 percent market risk premium and 6 percent risk free rate. a) What is the before-tax cost of debt? b) What is the cost of preferred shares? c) What is the firm's cost of equity using both the dividend growth model and the security market line? d) What is the firm's weighted average cost of capital (WACC)? The cost of equity to use for the WACC should be based on the security market line approach.
Explanation / Answer
a) Before cost of debt:
The cost of debt is the IRR of the cash flows associated with it.
Hence, 1040 = 1000*pvif(r,40) + 35*pvifa(r,40)
where 'r' is the half yearly discount rate.
The value of 'r' in the above equation is to be found out by trial and error by giving values to 'r' such that the LHS of the above equation is equal to 1040.
Using 3%
PV = 1000*0.3066 + 35*23.1148 = 1115.62
using 4%
PV = 1000*0.2083 + 35*19.7928 = 901.05
Exact value of r = 3 + (1115.62-1040)/(1115.62-901.05) = 3.35
Before tax cost of debt per annum = 3.35*2 = 6.7%.
b) Cost of preferred shares:
= Preference dividend/Market price = 8/105 = 7.62%.
c) Cost of equity:
As per CAPM Cost of equity (Ke) = Risk free rate + beta*market risk premium
= 6 +1.2*8 = 15.6%
As per dividend growth model (Ke) = (D1/P0) + g, where D1 is the expected dividend, P0 the current price and g the growth rate.
Ke = (4*1.07/53) + 0.07 = 15.08%
d) WACC:
For WACC the after tax cost of debt should be taken which is 6.7*0.6 = 4.02%
The WACC would be 10.52% as shown below:
# of shares/ Unit Total Specific Bonds MV MV Weight cost WACC Bonds 3000 1040 3120000 0.3371 4.02 1.36 Preferred shares 13000 105 1365000 0.1475 7.62 1.12 Common shares 90000 53 4770000 0.5154 15.6 8.04 9255000 1.0000 10.52Related Questions
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