Question

Collins Group
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.

Assets
Current assets	$  38,000,000
Net plant, property, and equipment	101,000,000
Total assets	$139,000,000
Liabilities and Equity
Accounts payable	$  10,000,000
Accruals	9,000,000
Current liabilities	$  19,000,000
Long-term debt (40,000 bonds, $1,000 par value)	40,000,000
Total liabilities	$  59,000,000
Common stock (10,000,000 shares)	30,000,000
Retained earnings	50,000,000
Total shareholders' equity	80,000,000
Total liabilities and shareholders' equity	$139,000,000

The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 25%.

1. Refer to the data for the Collins Group. Which of the following is the best estimate for the weight of debt for use in calculating the firm's WACC?

	a.	22.69%
	b.	21.61%
	c.	18.67%
	d.	19.60%
	e.	20.58%

2. Refer to the data for the Collins Group. Based on the CAPM, what is the firm's cost of common stock?

	a.	13.00%
	b.	12.35%
	c.	11.73%
	d.	13.65%
	e.	11.15%

Answer 1

Solution:

Question 1 .

We need to find the weight of debt, we have to find the market value of debt and market value of equity.

Market value of Debt = Current price of bond * Number of bonds = 875*40,000 = 35,000,000

Market value of equity = Current share price * Number of share = 15.25 *10,000,000 = 152,500,000

Weight of debt = Market value of debt / ( Market value of debt + Market value of Equity ) = 35,000,000 /(35,000,000 + 152,500,000) = 18.67%

Option C is correct

Question 2.

Risk free rate = 5.5% ( Since bond has maturity of 20 years hence we have chosen this time horizon for risk free rate)

Using CAPM,

Cost of common stock = Risk free rate + Beta * (Market return - Risk free rate ) = 5.50% + 1.25 * (11.50% - 5.50%) = 5.5% + 7.5% = 13%

Correct option is A ) 13%