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 $20 per share and has a beta of 0.7. There are 1 million common shares outstanding. The market risk premium is 9%, the risk-free rate is 5%, 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$3.0 Bonds, coupon = 7%, paid annually(maturity = 10 years, current yield to maturity = 9%)$10.0 Accounts receivable 5.0 Preferred stock (par value $20 per share) 3.0 Inventories 9.0 Common stock (par value $0.10) 0.1 Plant and equipment 20.0 Additional paid-in stockholders’ equity 16.9 Retained earnings 7.0 Total$37.0 Total$37.0

A. What is the market debt-to-value ratio?

B. What is the Universities WACC?

Explanation / Answer

a) Market Value of equity = No. of shares x Stock Price = 20 x 1 = 20 million

Market Value of preferred stock = No. of shares x Share Price = 3m / 20 x 30 = 4.5 million

Market Value of debt can be calculated using PV function = PV(rate = 9%, nper = 10, pmt = 7% x 10, fv = 10, 0) = 8.72 million

=> Total Market Value = $33.22

=> Market debt to value ratio, wd = 8.72 / 33.22 = 26.24%

b) Market equity to value ratio, we = 20 / 33.22 = 60.21%

Market preferred share to value ratio, wps = 4.5 / 33.22 = 13.55%

WACC = wd x kd x (1 - tax)+ wps x kps + we x ke

Here, kd - Cost of debt = 9%, kps - Cost of preferred stock = Dividend / Price = 3/30 = 10%, ke - cost of equity = Rf + beta x MRP = 5% + 0.7 x 9% = 11.3%

WACC = 26.24% x 9% x (1 - 40%) + 13.55% x 10% + 60.21% x 11.3% = 9.58%

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