Question

please help on question 2

Shrieves Company has been in the market for many years. Recently the company has decided to look seriously at a 5-year program and raise additional $15 million capital. Assume that you are the CFO of this company, and you need to decide the capital budgeting and evaluate the new program First, the company need estimate the optimal capital structure to minimize the total cost of raising new capital of the company. For long-term capital investment decisions, the company should consider three types of capital used to pay for long-term assets, which are typically long- term debt, preferred stock (if any), and common stock. You also know the following information of the company: The current price of the firm's $1.5/quarterly dividend, perpetual preferred stock is $110.14. • Currently, the company doesn't have any corporate bonds. However, the company's industries peers, similar size/business/risk, have outstanding corporate bonds, which might be useful to estimate the cost of debt (required return of bond) if the company issue bonds to raise capital: The current price of company A's 10 percent coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,140.72. The current price of company B's 8 percent coupon, semiannual payment, noncallable bonds with 10 years remaining to maturity is $1,200.30. ✓ The current price of company C's 12 percent coupon, semiannual payment, noncallable bonds with 13 years remaining to maturity is $1,350.54. • The company has 100,000 shares of stock outstanding, with a stock price of $143.5/share. Last year, the company had an EPS of $3 and paid a dividend of $90,000. The company also had a return on equity of 4.5 percent. You think the company will keep a constant DVD growth rate, which is close to this company's current growth rate. The firm's tax rate is 20 percent. After your analysis, you decide to only use corporate bond and common stock to raise capita thus, no preferred stocks). Your next task is to make a decision of the company's leverage. Thu Fou want to do a sensitivity analysis by estimating future cash flows based on different financi everage: Cash Flow with Different Leverage (in millions) Year 30% Debt 35% Debt 40% Debt 45% Debt 50% Debt -15 -15 -15 Nuru w wwNU

Answer 1

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Cost of debt

cost of debt = YTM * (1 - tax rate)

YTM is taken to be the average YTM of Company A, B and C's bonds.

Company A

YTM is calculated using RATE function in Excel with these inputs :

nper = 15*2 (15 years to maturity with 2 semiannual coupon payments each year)

pmt = 1000 * 10% / 2 (semiannual coupon payment = face value * annual coupon rate / 2. This is a positive figure as it is an inflow to the bondholder)

pv = -1140.72 (current bond price. This is a negative figure as it is an outflow to the buyer of the bond)

fv = 1000 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)

The RATE is calculated to be 4.17%. This is the semiannual YTM. To calculate the annual YTM, we multiply by 2. Annual YTM is 8.34%

Α1 f =RATE(15*2,1000*10%/2,-1140.72,1000) *2 D E F G А B C 1 8.34%!

Company B

YTM is calculated using RATE function in Excel with these inputs :

nper = 10*2 (10 years to maturity with 2 semiannual coupon payments each year)

pmt = 1000 * 8% / 2 (semiannual coupon payment = face value * annual coupon rate / 2. This is a positive figure as it is an inflow to the bondholder)

pv = -1200.30 (current bond price. This is a negative figure as it is an outflow to the buyer of the bond)

fv = 1000 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)

The RATE is calculated to be 2.69%. This is the semiannual YTM. To calculate the annual YTM, we multiply by 2. Annual YTM is 5.38%

A2 fx =RATE(10*2,1000*8%/2,-1200.3,1000)*2 D E F G B C 2 5.38%

Company C

YTM is calculated using RATE function in Excel with these inputs :

nper = 13*2 (13 years to maturity with 2 semiannual coupon payments each year)

pmt = 1000 * 12% / 2 (semiannual coupon payment = face value * annual coupon rate / 2. This is a positive figure as it is an inflow to the bondholder)

pv = -1350.54 (current bond price. This is a negative figure as it is an outflow to the buyer of the bond)

fv = 1000 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)

The RATE is calculated to be 3.84%. This is the semiannual YTM. To calculate the annual YTM, we multiply by 2. Annual YTM is 7.69%

A3 fic A B =RATE(13*2,1000*12%/2,-1350.54,1000)*2 D E F G H C 17.69%!

Average YTM of 3 companies = (8.34% + 5.38% + 7.69%) / 3 = 7.14%

cost of debt = YTM * (1 - tax rate)

cost of debt = 7.14% * (1 - 20%)

cost of debt   = 5.71%

Cost of preferred stock

cost of preferred stock = annual dividend / price per share

annual dividend = quarterly dividend * 4 = $1.5 * 4 = $6

cost of preferred stock = $6 / $110.14

cost of preferred stock = 5.45%

Cost of equity

cost of equity = (D₁ / P₀) + g,

where D₁ = next year dividend

P₀ = current share price

g = growth rate

g = ROE * retention ratio

retention ratio = 1 - (dividend per share / EPS)

dividend per share = dividends / shares outstanding = $90,000 / 100,000 = $0.90

retention ratio = 1 - ($0.90 / $3) = 70%

g = 4.5% * 70% = 3.15%

D₁ = current dividend per share * (1 + g) = $0.90 * (1 + 3.15%) = $0.92835

cost of equity = (D₁ / P₀) + g

cost of equity = ($0.92835 / $143.50) + 0.0315

cost of equity = 3.80%