LT devices Ltd. has 250,000 shares of common stock outstanding at a market price
ID: 2815641 • Letter: L
Question
LT devices Ltd. has 250,000 shares of common stock outstanding at a market price of $28 a share. Next year's annual dividend is expected to be $1.55 a share. The dividend growth rate is 2 percent. The firm also has 7,500 bonds outstanding with a face value of $1,000 per bond. The bonds carry a 7 percent coupon, pay interest semiannually, and mature in 7.5 years. The bonds are selling at 98 percent of face value. The company's tax rate is 34 percent. What is the firm's weighted average cost of capital?
(HINT: in a world with corporate taxes: WACC = rD*(1-Tc)*D/V+ rE*E/V)
Explanation / Answer
Given that - Equity shares of common stock outstanding 250000 market price per share 28 per share Next year's annual dividend $1.55 per share dividend growth rate 2% We know that as per DDM price per share = D1/(re-g) D1 = expected dividend next year $1.55 re= cost of equity/required rate on equity ? g=growth % 2% Therefore, =1.55/(re-2%)= 28 0.5600 or 1.55= 28re-0.56 or re= =(1.55+0.56)/28 or re = cost of equity 7.536% Also total value of equity = 250000*28 7000000 number of share * price per share Debt/bond Cost of bond will be YTM of the bond which is rate at which, present value of cash flow = PV of cash outflow Coupon rate = 7% semiannually Coupon rate = 3.5% for 6 month period Year to maturity = 7.5 year number of period = 15 semiannual period bond price = 980 Coupon interest = =1000*7%/2 35 as bond is issued at discount YTM will be higher than coupon rate. Lets discount the cash flow from bond using 3.6% and 3.7% discount rate period Cash flow 1.036 period interest 1.037 0 -980 1 (980.00) 0 -980 1 (980.00) 1 35 0.9653 33.78 1 35 0.9643 33.75 2 35 0.9317 32.61 2 35 0.9299 32.55 3 35 0.8993 31.48 3 35 0.8967 31.39 4 35 0.8681 30.38 4 35 0.8647 30.27 5 35 0.8379 29.33 5 35 0.8339 29.19 6 35 0.8088 28.31 6 35 0.8041 28.14 7 35 0.7807 27.32 7 35 0.7754 27.14 8 35 0.7536 26.37 8 35 0.7478 26.17 9 35 0.7274 25.46 9 35 0.7211 25.24 10 35 0.7021 24.57 10 35 0.6954 24.34 11 35 0.6777 23.72 11 35 0.6706 23.47 12 35 0.6542 22.90 12 35 0.6466 22.63 13 35 0.6314 22.10 13 35 0.6236 21.82 14 35 0.6095 21.33 14 35 0.6013 21.05 15 1035 0.5883 608.90 15 1035 0.5799 600.15 8.56 (2.71) This means that cost of debt is little higher than 3.6% per semiannual and lower than 3.7% semiannual basis we can use simple formula below to compute exact cost of debt Cost of debt pre tax Lower rate +(Lower rate NPV/(Lower rate NPV-Higher rate NPV))*Difference in rate =3.6%+((8.56/(8.56--2.71))*.1% 3.676% semiannually =(1+3.676%)^2-1 7.487% annually Therefore post tax cost of debt = =7.487%*(1-34%) 4.94% Value of debt = 7500*980 7350000 WACC = rD*(1-Tc)*D/V+ rE*E/V) =4.94%*7350000/(7350000+7000000)+7.536%*7000000/(7350000+7000000) 6.206%
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