Question

Assignment 3 At the beginning of the year, FPT Inc. had 1 million common shares outstanding. It also had total bonds outstanding worth $5 million. Recently, the company has decided to go through a financial restructuring. The company has issued additional 2000 bonds. Each bond has a face value of $1000, and will mature in 10 years. The company decided to offer an annual coupon rate so that the bonds could be sold at its face value (the company's outstanding bonds were also selling at their face value). The coupon rate that has been offered is 10%. The coupon will be paid annually. The company used all the proceeds from selling the additional bonds to buy back common shares. They bought each share at a price of $10 each. After the restructuring is complete, at present, each common share is trading at $10, and the bonds (both previously outstanding and the new issue) are trading at their face value. Your job is to calculate the weighted average cost of capital of the company after the financial restructuring. To do that, you have also acquired additional information. The company faces a tax rate of 30%. You have decided to use the SML equation to calculate the cost of common equity. You estimate that the risk-free rate is 5%, and the market risk premium is 5% as well and the beta of of the firm is 1.7578. What is the WACC of the company at this point?

Answer 1

First we need to calculate common shares outstanding after buy back of common shares.

shares outstanding after buy back = original shares outstanding - no. of shares bought back

no. of Shares bought back = selling proceeds from additional bonds issued/price of shares bought back = ($1,000*2,000)/$10 = $2,000,000/$10 = 200,000

shares outstanding after buy back = 1,000,000 - 200,000 = 800,000

Total capital = value of bonds + value of common shares = ($5,000,000 + $2,000,000) + (800,000*$10) = $7,000,000 + $8,000,000 = $15,000,000

Weight of bonds = value of bonds/Total capital = ($5,000,000 + $2,000,000)/$15,000,000 = $7,000,000/$15,000,000 = 0.47

Weight of common shares = $8,000,000/$15,000,000 = 0.53

Weighted average cost of capital = Weight of bonds*after-tax cost of bonds + Weight of common shares*cost of common shares

after-tax cost of bonds = before-tax cost of bonds*(1-tax rate)

before-tax cost of bonds is the yield to maturity of the bonds. as bonds are trading at their face value, so yield to maturity of the bonds and their coupon rate will be equal. hence, before-tax cost of bonds is 10% which is the coupon rate.

after-tax cost of bonds = 10%*(1-0.30) = 10%*0.70 = 7%

cost of common shares = risk-free rate + beta of firm*market risk premium = 5% + 1.7578*5% = 5% + 8.789% = 13.789%

Weighted average cost of capital = 0.47*7% + 0.53*13.789% = 3.29% + 7.30817% = 10.598% or 10.6%