Chapter 12 Finance

Vedder, Inc., has 5 million shares of common stock outstanding. The current share price is $73, and the book value per share is $9. Vedder also has two bond issues outstanding. The first bond issue has a face value of $60 million, a coupon rate of 7 percent, and sells for 98 percent of par. The second issue has a face value of $40 million, a coupon rate of 6.5 percent, and sells for 97 percent of par. The first issue matures in 20 years, the second in 12 years. Required: (a) What are the company's capital structure weights on a book value basis? (b) What are the company's capital structure weights on a market value basis? (c) Which are more relevant, the book or market value weights?

(a) The book value of equity is the book value per share times the number of shares, and the book value of debt is the face value of the company's debt, so: BVE = 5,000,000($9) = $45,000,000 BVD = $60,000,000 + 40,000,000 = $100,000,000 So, the total value of the company is: V = $45,000,000 + 100,000,000 = $145,000,000 And the book value weights of equity and debt are: E/V = $45,000,000 / $145,000,000 = .3103 D/V = 1 - E/V = .6897 (b) The market value of equity is the share price times the number of shares, so: MVE = 5,000,000($73) = $365,000,000 Using the relationship that the total market value of debt is the price quote times the par value of the bond, we find the market value of debt is: MVD = .98($60,000,000) + .97($40,000,000) = $97,600,000 This makes the total market value of the company: V = $365,000,000 + 97,600,000 = $462,600,000 And the market value weights of equity and debt are: E/V = $365,000,000/$462,600,000 = .7890 D/V = 1 - E/V = .2110 (c) The market value weights are more relevant because they represent a more current valuation of the debt and equity.

Jiminy's Cricket Farm issued a 30-year, 6.5 percent semiannual bond 7 years ago. The bond currently sells for 107 percent of its face value. The company's tax rate is 35 percent. Required: (a) What is the pretax cost of debt? (b) What is the aftertax cost of debt? (c) Which is more relevant, the pretax or the aftertax cost of debt?

(a) The pretax cost of debt is the YTM of the company's bonds, so: P0 = $1,070 = $32.50(PVIFAR%,46) + $1,000(PVIFR%,46) R = 2.969% YTM = 2 × 2.969% YTM = 5.94% (b) The aftertax cost of debt is: RD = .0594(1 - .35) RD = .0386, or 3.86% (c) The aftertax rate is more relevant because that is the actual cost to the company.

ICU Window, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with seven years to maturity that is quoted at 108 percent of face value. The issue makes semiannual payments and has an embedded cost of 6.1 percent annually. Requirement 1: What is ICU's pretax cost of debt? Requirement 2: If the tax rate is 38 percent, what is the aftertax cost of debt?

1: The pretax cost of debt is the YTM of the company's bonds, so: P0 = $1,080 = $30.50(PVIFAR%,14) + $1,000(PVIFR%,14) R = 2.371% YTM = 2 × 2.371% YTM = 4.74% 2: And the aftertax cost of debt is: RD= .0474(1 - .38) RD = .0294, or 2.94%

Benjamin Manufacturing has a target debt-equity ratio of .45. Its cost of equity is 12 percent, and its cost of debt is 7 percent. Required: If the tax rate is 35 percent, what is the company's WACC?

Here, we need to use the debt-equity ratio to calculate the WACC. A debt-equity ratio of .45 implies a weight of debt of .45/1.45 and an equity weight of 1/1.45. Using this relationship, we find: WACC = .12(1/1.45) + .07(.45/1.45)(1 - .35) WACC = .0969, or 9.69%

Halestorm Corporation's common stock has a beta of 1.15. Assume the risk-free rate is 3.9 percent and the expected return on the market is 12 percent. Required: What is the company's cost of equity capital?

Here we have information to calculate the cost of equity, using the CAPM. The cost of equity is: RE = .039 + 1.15(.12 - .039) RE = .1322, or 13.22%

Sixth Fourth Bank has an issue of preferred stock with a $6.25 stated dividend that just sold for $108 per share. Required: What is the bank's cost of preferred stock?

The cost of preferred stock is the dividend payment divided by the price, so: RP = $6.25 / $108 RP = .0579, or 5.79%

Stock in CDB Industries has a beta of .90. The market risk premium is 7 percent, and T-bills are currently yielding 3.5 percent. CDB's most recent dividend was $1.80 per share, and dividends are expected to grow at a 5 percent annual rate indefinitely. Required: If the stock sells for $47 per share, what is your best estimate of CDB's cost of equity?

We have the information available to calculate the cost of equity, using the CAPM and the dividend growth model. Using the CAPM, we find: RE = .035 + .90(.07) = .0980, or 9.80% And using the dividend growth model, the cost of equity is RE = [$1.80(1.05) / $47] + .05 = .0902, or 9.02% Both estimates of the cost of equity seem reasonable based on the historical return on large capitalization stocks. Given this, we will use the average of the two, so: RE = (.0980 + .0902) / 2 = .0941, or 9.41%

You are given the following information concerning Parrothead Enterprises: Debt: 10,000 6.9 percent coupon bonds outstanding, with 15 years to maturity and a quoted price of 104. These bonds pay interest semiannually. Common stock: 275,000 shares of common stock selling for $68.50 per share. The stock has a beta of .85 and will pay a dividend of $3.25 next year. The dividend is expected to grow by 5 percent per year indefinitely. Preferred stock: 8,000 shares of 4.9 percent preferred stock selling at $94 per share. Market: 12 percent expected return, a risk-free rate of 3.5 percent, and a 35 percent tax rate. Required: Calculate the WACC for Parrothead Enterprises.

We will begin by finding the market value of each type of financing. We find: MVD = 10,000($1,000)(1.04) = $10,400,000 MVE = 275,000($68.50) = $18,837,500 MVP = 8,000($94) = $752,000 And the total market value of the firm is: V = $10,400,000 + 18,837,500 + 752,000 V = $29,989,500 Now, we can find the cost of equity using the CAPM. The cost of equity is: RE1 = .035 + .85(.12 - .035) RE1 = .1073, or 10.73% We can also find the cost of equity, using the dividend discount model. The cost of equity with the dividend discount model is: RE2 = ($3.25 / $68.50) + .05 RE2 = .0974, or 9.74% Both estimates for the cost of equity seem reasonable, so we will use the average of the two. The cost of equity estimate is: RE = (.1073 + .0974) / 2 RE = .1023, or 10.23% The cost of debt is the YTM of the bonds, so: P0 = $1,040 = $34.50(PVIFAR%,30) + $1,000(PVIFR%,30) R = 3.24% YTM = 3.24% × 2 YTM = 6.48% And the aftertax cost of debt is: RD = (1 - .35)(.0648) RD = .0421, or 4.21% The cost of preferred stock is: RP = $4.90/$94 RP = .0521, or 5.21% Now, we have all of the components to calculate the WACC. The WACC is: WACC = .0421($10,400,000 / $29,989,500) + .0521($752,000 / $29,989,500) + .1023($18,837,500 / $29,989,500) WACC = .0802, or 8.02%

Information on Janicek Power Co., is shown below. Assume the company's tax rate is 35 percent. Debt: 8,500 7.2 percent coupon bonds outstanding, $1,000 par value, 25 years to maturity, selling for 118 percent of par; the bonds make semiannual payments. Common stock: 225,000 shares outstanding, selling for $87 per share; beta is 1.15. Preferred stock: 15,000 shares of 4.8 percent preferred stock outstanding, currently selling for $98 per share. Market: 7 percent market risk premium and 3.1 percent risk-free rate.

We will begin by finding the market value of each type of financing. We find: MVD = 8,500($1,000)(1.18) = $10,030,000 MVE = 225,000($87) = $19,575,000 MVP = 15,000($98) = $1,470,000 And the total market value of the firm is: V = $10,030,000 + 19,575,000 + 1,470,000 V = $31,075,000 Now, we can find the cost of equity using the CAPM. The cost of equity is: RE = .031 + 1.15(.07) RE = .1115, or 11.15% The cost of debt is the YTM of the bonds, so: P0 = $1,180 = $36(PVIFAR%,50) + $1,000(PVIFR%,50) R = 2.91% YTM = 2.91% × 2 YTM = 5.82% And the aftertax cost of debt is: RD = (1 - .35)(.0582) RD = .0379, or 3.79% The cost of preferred stock is: RP = $4.80 / $98 RP = .0490, or 4.90% Now we have all of the components to calculate the WACC. The WACC is: WACC = .0379($10,030,000 / $31,075,000) + .1115($19,575,000 / $31,075,000) + .0490($1,470,000 / $31,075,000) WACC = .0848, or 8.48% Notice that we didn't include the (1 - TC) term in the WACC equation. We used the aftertax cost of debt in the equation, so the term is not needed here.

The Lo Tech Co. just issued a dividend of $1.80 per share on its common stock. The company is expected to maintain a constant 6 percent growth rate in its dividends indefinitely. Required: If the stock sells for $41 a share, what is the company's cost of equity?

With the information given, we can find the cost of equity using the dividend growth model. Using this model, the cost of equity is: RE = [$1.80(1.06) / $41] + .06 RE = .1065, or 10.65%