Question

Please, help!!

Traxo Manufacturing Ltd. shares are publicly traded on the Toronto Stock Exchange under the ticker symbol TRX.TO. The shares currently trade at a price of $2.25 per share. Security analysts that follow the stock have estimated it's beta coefficient to be 0.9. Traxo paid a dividend on its common stock last year that totaled $0.08 per share. Dividends have been growing at a 3.25% compound rate for the past three years and the expectation is that this growth can continue into the foreseeable future.

Traxo Manufacturing Ltd. has an important warehouse capital project to consider. The warehouse project is expected to produce annual cash flows before tax of $290,000 for each of the next twelve years. The warehouse project is thought to be of similar risk to the risk of the firm itself. It will cost Traxo $750,000 this year to get this project up and running.

Traxo has it's long-term bonds trading on public markets. The bonds are currently trading at a premium from their par value of 101.34%. These 6.35% bonds have eleven years left until they mature.

Siri Li, Traxo's manager of finance has collected current data from the firm's underwriters. The risk-free rate is estimated to 1.01%. The expected return on the S&P/TSX Capped Total Return Composite index is forecast to be 7.5% in 2020. New equity capital could be raised by the firm at the current market price, but floatation costs would amount of 5% of the value of the issue. New bonds could be sold into the market, but the floatation cost percentage would be 4%. The firm faces a corporate tax rate of 35%. If the firm goes ahead with the capital project, it will have to seek external financing.

The firm's most recent financial statements are found below:

Traxo Manufacturing Ltd. Balance Sheet As at December 31, 2019 In $ '000s Liabilities: Accruals Accounts Payable 30 312 Assets: Cash 100 Accounts Receivable 1,220 Inventories 2,450 Total Current Assets 3,770 Gross Fixed Assets 5,000 Accumulated Depreciation 1,500 342 4,000 Total Current Liabilities 6.35% bonds (due 2030) Common stock (2 million outstanding) Retained earnings TOTAL CLAIMS Net Fixed Assets TOTAL ASSETS 3,500 7,270 1,000 1,928 7,270

1. Estimate the investor’s required rate of return on Traxo’s debt. (Use the approximation formula to determine the yield to maturity on outstanding bonds given the current price bonds are trading for in the market). (Demonstrate the formula and solution step by step)

2. What is the after-tax, and after-floatation cost of existing debt? (Demonstrate the formula and solution step by step)

3. Estimate the investor’s required rate of return (cost of retained earnings) using the constant growth dividend discount model (DDM). (Demonstrate the formula and solution step by step)

4. Estimate the investor’s required rate of return (cost of retained earnings) using the CAPM. (Demonstrate the formula and solution step by step)

5. Estimate the cost of external (new) equity capital after floatation costs using the CAPM. (Demonstrate the formula and solution step by step)

6. Find the Weighted Average Cost of Capital for Traxo using market value weights and assuming the firm uses retained earnings for equity financing. (Use the CAPM approach to estimate the equity investor’s required rate of return.) (Demonstrate the formula and solution step by step)

7. Find the market value weights of debt and equity in Traxo’s capital structure. (Demonstrate the formula, steps in solution and the result using MS EXCEL)

8. Find the Weighted Average Cost of Capital for Traxo assuming the firm must use external equity rather than use retained earnings. (Use market value weights.) (Demonstrate the formula, steps in solution and the result using MS EXCEL)

9. Assuming Traxo must use external equity financing, is the proposed project viable? Show your calculations step by step. (You will need to calculate the project’s NPV using the firm’s WACC assuming the use of external equity capital rather than retained earnings.).

Answer 1

1). Cost of debt calculation using approximation formula:

Cost of debt = [annual interest + (1,000-current price)/years to maturity]/[1,000 + current price]/2, assuming that par value is 1,000

Current price = 101.34%*1,000 = 1,013.4

Annual interest = 6.35%*1,000 = 63.50

number of years to maturity = 11

Pre-tax cost of debt = [63.5 + (1,000-1,013.4)/11]/[1,000 + 1,013.4]/2 = 6.19%

2). After-tax cost of debt of existing debt = pre-tax cost of debt*(1-Tax rate) = 6.19%*(1-35%) = 4.02%

For new debt, flotation cost is 4%. Since, it is not mentioned if approximation formula is to be used here or not, we will find the after-flotation cost of debt using the exact method:

FV (par value) = 1,000; PV (current proceeds from sale of new debt) = 1,013.4*(1-4%) = 972.86; N (number of years left) = 11; PMT (annual coupon) = 63.50, solve for RATE.

YTM = 6.71%

After-tax cost of new debt = 6.71%*(1-35%) = 4.36%

Note: The question is wrongly worded. Only to be issued debt has flotation costs associated with it, not existing debt.

3). Cost of retained earnings (using DDM) = expected dividend/current price + growth rate

The given growth rate of 3.25% is mentioned as compound rate over 3 years so annual growth rate will be

(1+3.25%)^(1/3) -1 = 1.07%

Cost of retained earnings = [0.08*(1+1.07%)/2.25] + 1.07% = 4.67%

Note: This cost is low compared to standard required returns for equity as it is in line with the cost of debt. Ideally, it should be much higher. Please confirm if the growth rate of 3.25% is the compound rate or annual rate only. If it is annual rate then cost of retained earnings will be 6.92%

4). Cost of retained earnings (using CAPM) = risk-free rate + beta*(market return - risk-free rate)

= 1.01% + 0.9*(7.5%-1.01%) = 6.85%