Question

You are given the following information about a company. Their tax rate is 34%. The firm is in need of $5 million dollars in external funds. Your bond advisor suggests that new bond issues can be lower than the current yield to maturity by 2.0%. You are not sure he is correct. Should you issue the new debt to raise money Existing capital structure: Debt: 5,000 Eight percent (8%) coupon bonds outstanding. The par value is $1000 and they mature in ten years. They are currently selling for $1250 and make semiannual payments Equity: 50.000 shares outstanding. The common stock is currently selling for $72 per share The beta for the company is 1.15. Preferred Stock: 10,000 shares of 2% preferred stock with a par value of $100, and is currently selling for $65 per share. Market Information: The market return is 6% and the risk-free rate is 2%. The industry debt- equity ratio is 33% The flotation rate for new debt is 3% and for new equity it is 5% Im having trouble with figuring this out in excel. Please help! 1 Calculate the existing weighted average cost of capital 2 New cost of capital if add 5M in new bends. This assumes we sell enough bonds to realize 5M. Since the price will be net of flotation we need to sell them at $1,250 but net a bit less. 3 What if they finance the 5M with all equity? What would the capital structure and WACC look like? 4 What if they add 5M in financing split among debt and equity in proportions equal to the current capital structure. What is the WACC? D. Focus Hi

Answer 1

Given,

Remarks	Particulars	Amount
t	Tax Rate	34%
	Fund requirements	5,000,000
	New bond issue lower than current yield to maturity by	2.00%
	Existing
	5000, 8% Debt maturing in 10 years	5,000,000
	Current Market Price	1,250
	Payment frequency	Semi Annual
	50,000 Equity shares	5,000,000
	Current Market Price	72
B	Beta	1.15
	10,000, 2% Preferred shares	1,000,000
	Current Market Price	65
Rm	Market Return	6.00%
Rf	Risk free rate	2.00%
	Debt Equity Ratio of industry	33.00%
Fd	Flotation Rate for new debt	3.00%
Fe	Flotation Rate for new equity	5.00%

1	WACC = (E/ (MV))*Ke + (D/ (MV))*Kd*(1-t) + (P/MV)*Kp

E=Market value of equity	3,600,000
D=Market value of debt	6,250,000
P= Market value of Preferred stock	650,000
MV = Market value of Total capital	10,500,000
Ke= Rf + (Rm-Rf)*B = Cost of equity	6.60%
Kd = Cost of debt	8.00%
Kp= Cost of Preferred Stock	2.00%
t=Tax rate	34.00%
WACC =	5.53%

2	New WACC after adding $5m new bonds

E=Market value of equity	3,600,000
D1=Market value of debt -existing	6,250,000
D2=Market value of debt - new	5,000,000
P= Market value of Preferred stock	650,000
MV = Market value of Total capital	15,500,000
Ke= Rf + (Rm-Rf)*B	6.60%
Kd1 = Cost of debt - existing	8.00%
Kd2 = Cost of debt - new	6.1856%
Kp= Cost of Preferred Stock	2.00%
t=Tax rate	34.00%
WACC =	5.06%

3	New WACC after adding $5m equity

E1 =Market value of equity - existing	3,600,000
D1=Market value of debt -existing	6,250,000
E2=Market value of equity - new	5,000,000
P= Market value of Preferred stock	650,000
MV = Market value of Total capital	15,500,000
Ke1= Rf + (Rm-Rf)*B	6.60%
Ke2= (Rf + (Rm-Rf)*B)/(1-Fe)	6.95%
Kd1 = Cost of debt - existing	8.00%
Kp= Cost of Preferred Stock	2.00%
t=Tax rate	34.00%
WACC =	5.99%

4	New WACC after adding $5m in current capital structure, i.e. 1:1 assuming capital structure taken at book value

E1 =Market value of equity - existing	3,600,000
D1=Market value of debt -existing	6,250,000
E2=Market value of equity - new	2,500,000
D2=Market value of debt - new	2,500,000
P= Market value of Preferred stock	650,000
MV = Market value of Total capital	15,500,000
Ke1= Rf + (Rm-Rf)*B	6.60%
Ke2= (Rf + (Rm-Rf)*B)/(1-Fe)	6.95%
Kd1 = Cost of debt - existing	8.00%
Kd2 = Cost of debt - new	6.1224%
Kp= Cost of Preferred Stock	2.00%
t=Tax rate	34.00%
WACC =	5.52%