Question

GB Timbers, based in Germany, supplies timber products to construction and manufacturing industries. The company reported after-tax earnings available to common stocks of RM3,200,000. From these eamings, the management decided to pay a dividend of RM0.80 on each of its 4,000,000 common shares outstanding. The capital structurë of the company includes 30% debt, 40% common stock, end 30% preferred stock. The tax rate applicable to GB Timbers is 30%.

i) If the market price of the common stock is RM3.60,) and dividend is expected to grow at a rate of 8% per year for the foreseeable future, Ahat is the required rate of return on the company's common stock? (2 marks)

ii) The company can issue a RM1.00 dividend preferred stock for a market price of RM10.00 per share. The floatation costs would amount to RMO.60 per share. What is the cost of preferred stock financing? (2 marks)

iii) In addition, the company can issue RM100 per value, 8% coupon, 10 year bonds that can be sold for RM110 each. Floatation costs would amount to RM2 per bond. Use the estimation formula to figure the approximate cost of debt financing. (2 marks)

iv) What is the Weighted Average Cost of Capital (WACC)? (2 marks)

Answer 1

PAT = RM 3,200,000

Dividend = RM 0.80

Common Shares Outstanding = 4,000,000

Capital Structure -

Debt = 30%

Common Stock = 40%

Preferred Stock = 30%

Tax Rate = 30%

Ans 1 -

P0 = D1 / (ke- g)

Where

P0 = Current Market Price of Stock = RM 3.60

D1 = Expected Dividend = RM 0.80

g = Dividend Growth Rate = 8%

ke= Cost of Equity

P0 = D1 / (ke- g) = 3.60 = 0.80 / (ke -0.08)

3.60ke - (0.08*3.60) = 0.80

3.60ke = 0.80 + (0.08*3.60) or 3.60ke = 1.088 or ke = 1.088 / 3.60

ke = 0.3022 or 30.22%

Ans 2 -

Fixed Dividend on Preferred Stock = RM 1.00

Preferred Stock Value = RM 10.00

Flotation Costs = RM 0.60

Net Proceeds = RM 10.00 - RM 0.60 = RM 9.40

Cost of Preferred Stock = Fixed Dividend / Net Proceeds = RM 1.00 / RM 9.40 = 0.1064 or 10.64%

Ans 3 -

Cost of Debt = Coupon + ((Face Value - Price) / Number of Years) / (Face Value + Price) / 2

Coupon = 8%

Face Value = RM 100.00

Number of Years = 10

Current Price = RM 110.00

Flotation Cost = RM 2.00

Price after Flotation Cost = Current Price - Flotation Cost = RM 110.00 - RM 2.00 = RM 108.00

Cost of Debt = 8.00 + ((100 - 108) / 10) / (100+ 108) / 2 = 0.0692 or 6.92%

Ans 4 -

WACC = Equity Ratio * Cost of Equity + Preferred Ratio * Cost of Preferred Stock + Debt Ratio * Cost of Debt * (1 - Tax Rate)

Debt Ratio = 30%

Common Stock Ratio = 40%

Preferred Stock Ratio = 30%

Cost of Equity = 30.22%

Cost of Preferred Stock = 10.64%

Cost of Debt = 6.92%

Tax Rate = 30%

WACC = Equity Ratio * Cost of Equity + Preferred Ratio * Cost of Preferred Stock + Debt Ratio * Cost of Debt * (1 - Tax Rate)

WACC = 40% * 30.22% + 30% * 10.64% + 30 * 6.92% * (1-0.30)

WACC = 16.73%

Hope this helps. Thanks and have a good day.