FIN461 Homework 9 1.0 Point Deadline: Monday April 11, 2016 before 11:00pm This
ID: 2761007 • Letter: F
Question
FIN461 Homework 9 1.0 Point Deadline: Monday April 11, 2016 before 11:00pm This homework is an individual assignment; therefore, working with or copying from other students is strictly prohibited. Rotvec Manufacturing Company (RMC) is a publicly held company with common stock listed on the Zurich Stock Exchange (ZSE) and bonds traded over the counter. As of the current balance sheet, it has three bond issues outstanding: $150 million of 10 percent series 2021 $50 million of 7 percent series 2019 $60 million of 6 percent series 2017 __________________________________________________ The finance manager of the company, Mr. Briman, is planning to sell $60 million of bonds next year to replace the debt due to expire in late 2017. Present market yields on similar Baa-rated bonds are 12.80 percent. RMC also has $90 million of 7.5 percent non-callable preferred stock outstanding, and it has no intentions of selling any preferred stock at any time in the future. The preferred stock is currently priced at $80 per share at ZSE, and its dividend per share is $7.80. The company has had very volatile earnings, but its dividends per share have had a very stable growth rate of 6 percent and this will continue. Last dividend paid by RMC was $1.76 per share, and the common stock is selling for $40 per share. The company’s investment banker has quoted the following flotation costs to RMC: $2.30 per share for preferred stock and $2.10 per share for common stock. RMC has kept its debt at 50 percent of assets and its equity at 50 percent. RMC sees no need to sell either common or preferred stock in the foreseeable future as it has generated enough internal funds for its investment needs when these funds are combined with debt financing. RMC’s corporate tax rate is 35 percent. Please compute: 1. Cost of Bond (debt). 2. Cost of Preferred stock. 3. Cost of Common equity in the form of retained earnings. 4. Cost of New common stock. 5. WACC.
Explanation / Answer
Calculation of cost of bond:
In bond, interest is annually paid. It is the cash outflow expeceted from bond. If a bond has 10% coupon rate then company has to earn at least 10% to satisfy them. However interest paid on bond is eligible for considering as expenses in taxable income calculation. So company can reduce tax liability. It will reduce effective cost of capital of bomd. Thus formula used for calculating cost of bond is-
Cost of bond = Coupon rate (1- tax rate per dollar)
At present company has issued three different series of bond their cost of debt are as follows:
a. Cost of 10% bond of series 2021 is-
=10% (1-0.35) = 6.5% [Note: tax rate is 35%. So 0.35 is taken here as tax benefit on coupon rate]
b. Cost of 7% bond series 2019 is-
=7% (1-0.35)=4.55%
c. Cost of 6% series 2017 is-
=6% (1-0.35)=3.9%
Now consider a new bond which will be replaced for vexisting third series of 2017. As current market yield of similar bond is 12.80%, you can assume that new series that will be issued in next year will be issued at a coupon rate of 12.80%. So its cost of capital will be-
=12.80%(1-0.35)= 8.32%
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2. Cost of preferred stocK:
It is the stock which will enjoy preferential right over equity stock. At present some preferrred stock are available in the market at quoted price of $80. Dividend paid on preferred stock is 7.80. It will not be repaid. So its life is infinity. As dividend is paid no tax benefit is available. Thus calculation of preferred stock cost of capital (KP) is-
[7.8/(1+KP)] + [7.8/(1+KP)2]+............................upto infinity = $80
Here left side is a infinity GP series with first term 7.8/(1+KP) and common ratio 1/(1+KP). Sumation formula is :
Sum = first term/ (common ratio -1)
Therefore,
[7.8/(1+KP)]/[1-[1/(1+KP)]]=80
7.8/KP=80
KP=80/7.8=10.2564%
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3. Cost of equity (Ke):
It is based on the same concept of present value calculation. Here dividend is expeced to grow at 6%. Current dividend is $1.76. Price quoted is $40. Thus-
[1.76(1.06)]/(1+Ke) + [1.76(1.06)2]/(1+Ke)2 +......... upto infinity=$40
Left side is again an infinity GP series with first term [1.76(1.06)/(1+Ke)] and common ratio 1.06/(1+Ke). Therefore applying summation formula the expansion is-
[1.76(1.06)/(1+Ke)]/[1-[(1.06)/(1+Ke)]]=$40
[1.8656/(1+Ke)]/[(1+Ke-1.06)/(1+Ke)]=$40
[1.8656/(Ke-0.06)]=40
Ke-0.06=1.8656/40=0.04664
Ke=0.06+0.04664=0.10664
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4. Cost of new equity:
When new common stock will be issued, flotation cost will reduce realizable value. So in the previous formula replace market realizable price of $40 by $37.90. The change is flotation cost of $2.10.
Hence cost of new equity is-
Ke-0.06=1.8656/37.90
Ke=0.04922+0.06=0.10922
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5. Finally consider weighted cost of capital. Here you have to ascertain weighted average figure. For this consider weights. It can be book value or market value. Let us consider book value. For equity stock book value are not available. But it has been stated that company is maintaining 50-50 debt equity ratio. Equity includes preferred as well as common stock. On this basis following table has been prepared
Answer: WACC is 8.046 percent
Sources Value weight Costof capital weightxcost of capital Bond series 2021 $150m. 0.288 6.5% 1.872 Bond series 2019 $50m. 0.096 4.55% 0.437 Bond series 2017 $60m 0.116 3.9% 0.452 Total $260m. 0.500 Preferred stock $60m. 0.116 10.256% 1.190 Common stock $200m. 0.384 10.664 4.095 WACC 8.046Related Questions
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