Question

My question is Q 12 , book value vs market value , thank you !

TUE 95 percent of its face Ulte is 15 percent a. What is the pretax cost of debt? b. What is the aftertax cost of debt? c. Which is more relevant, the pretax or the aftermax cost of debt? Why? Calculating Cost of Debt O2 For the firm in Problem 7. suppose the book value of the debt issue is $85 million. In addition, the company has a second debt issue on the market, a zero coupon bond with 12 years left to maturity: the book value of this issue is $35 million, and the bonds sell for 59 percent of par. What is the company's total book value of debt? The total market value? What is your best estimate of the aftertax cost of debt now? Calculating WACC Mallineaux Corporation has a target capital structure of 70 percent common stock, 5 percent preferred stock, and 25 percent debt. Its cost of equity is li percent, the cost of preferred stock is 5 percent, and the pretax cost of debt is 7 percent. The relevant tax rate is 35 percent. a. What is Mullineaux's WACC) b. The company president has approached you about Mullineaux's capital structure. He wants to know why the company doesn't use more preferred stock financing because it costs less than debt. What would you tell the president? 10 Taxes and WACC LO3] Lannister Manufacturing has a target debt-equity ratio of 2 35. Its cost of equity is 12 percent, and its cost of debt is 6 percent. If the tax rate is 35 percent, what is the company's WACC? 11. Finding the Target Capital Structure [LO3] Fama's Llamas has a weighted aver- age cost of capital of 8.5 percent. The company's cost of equity is 1l percent, and its pretax cost of debt is 6. I percent. The tax rate is 35 percent. What is the company's target debt-equity ratio? 12. Book Value versus Market Value [LO3] Dinklage Corp. has 8 million shares of common stock outstanding. The current share price is $73, and the book value per share is $7. The company also has two bond issues outstanding. The first bond issue has a face value of $85 million, a 7 percent coupon, and sells for 97 percent of par. The second issue has a face value of $50 million, an 8 percent coupon, and sells for 108 percent of par. The first issue matures in 21 years, the second in 6 years. a. What are the company's capital structure weights on a book value basis? b. What are the company's capital structure weights on a market value basis? c. Which are more relevant, the book or market value weights? Why? 13. Calculating the WACC (LO3] In Problem 12, suppose the most recent dividend was $3.90 and the dividend growth rate is 6 percent. Assume that the overall cost of debt is the weighted average of that implied by the two outstanding debt issues. Both bonds make semiannual payments. The tax rate is 35 percent. What is the company's WACC?

Answer 1

All financials are in $ million; number of shares are in million and price per share is in $.

Part (a)

Book Value of first bond, D1 = 85; Book value of second bond, D2 = 50; Book value of equity = E = Book value per share x Nos. of shares = 7 x 8 = 56

Total capital, C = D1 + D2 + E = 85 + 50 + 56 = 191

Hence, capital structure weight based on book values:

Proportion of first bond in capital structure = Wd1 = D1 / C = 85 / 191 = 44.50%

Proportion of second bond in capital structure = Wd2 = D2 / C = 50 / 191 = 26.18%

Proportion of equity in capital structure = We = 1 - Wd1 - Wd2 = 1 - 44.50% - 26.18% = 9.32%

Part (b)

Market Value of first bond, D1 = 85 x 97% = 82.45; Book value of second bond, D2 = 50 x 108% = 54; Market value of equity = E = Price per share x Nos. of shares = 73 x 8 = 584.00

Total capital, C = D1 + D2 + E = 82.45+ 54.00 + 584.00= 720.45

Hence, capital structure weight based on market values:

Proportion of first bond in capital structure = Wd1 = D1 / C = 82.45 / 720.45 = 11.44%

Proportion of second bond in capital structure = Wd2 = D2 / C = 54 / 720.45 = 7.50%

Proportion of equity in capital structure = We = 1 - Wd1 - Wd2 = 1 - 11.44% - 7.50% = 81.06%

Part (c)

Market value weights are more relevant. Cost of capital is used as the discount rate to discount the expected cash flows under the discounted cash flow method to obtain the market value of the firm. SInce the output is market value, the inputs should also be commensurate with output and must be inouts based on market value. Hence WACC should be based on market value weights. Further, market value reflects the true and prevailing value of the sources of capital. Book values may be understated, historical and hence not irrelevant. Hence, one must use weightes derived from market values.