Question

Amount in million) $1,000 Sources of Capital 10% Bond 12% Preference Share (10m shares) Common stoks (30m shares) Total $1,000 $3,000 $5,000 The bond of POZ will mature in 5 years (from now) has yield to maturity of 8%. While the preference share is currently trading at $115 per share, the market price of POZ's common stock is $259. The common stock has beta of 1.25 and the corporate tax rate applicable to PQZ is 30%. The T-bill rate is 4% and excess market return is 6%. a. Compute the cost of debt after tax, cost of preference share and cost of common stock for POZ. [2+2+3] b. Prepare a market value based capital structure of PQZ, i.e. compute the market value of bonds, preference shares and common stocks. (8 marks] c. What is the weighted average cost of capital (WACC)? Note that WACC should be based on market value weights (why?).

I am quite pressed for time! Can someone help me find this solution?

Answer 1

A. Calculation of cost of capital

• In order to calculate Cost of Debt, we have to calculate market value of debt. This can be estimated by calculating bond price from the data shared. Bond price = (CI * (1 - (1 / (1 + YTM) ^ n)) / YTM) + (FV * 1 / (1 + YTM) ^ n) where CI = Coupon interest = $1,000 mn * 10% = $100 mn, YTM = Yield-to-Maturity = 8%, FV = Face Value = $1,000 mn, n = period = 5 years. Solving this equation, we get markt value of debt = $1,079.85 million. Hence Post-tax Cost of Debt = Coupon Interest / Market Value of Bond * (1 - Interest rate) = $100 million / $1,079.85 million * (1 - 30%) = 6.48%.
• Cost of Preferred Stock = Preferred dividend / Market value of Preferred Stock. Preferred dividend = 12% * Face Value = 12% *  $1,000 million / 10 million = $12. Hence Cost of Preferred Stock = $12 / $115 = 10.43%
• Cost of Equity can be calculated as: Risk free rate + beta * market risk premium. We can consider T-bill rate of 4% as risk free rate and excess market return of 6% as market risk premium. Hence Cost of Equity = 4% + 1.25 * 6% = 11.50%

B. Market value based capital structure is calculated as per the following table:

	Market value in $mn
Debt	$1,079.85
Preferred Stock	$1,150.00
Equity	$7,770.00
Total	$9,999.85

Market value of preferred stock and equity is calculated by multiplying no. of shares and market price for each

C. WACC is the weighted average cost calculated by the formula: (Cost of Debt * Market Value of Debt + Cost of Preferred Stock * market value of Preferred Stock + Cost of Equity * market value of Equity) / (market value of Debt + market value of Preferred Stock + market value of Equity). Using the answers in A and B, we can get WACC as 10.84%. WACC should be based on market value weights and not book value weights because Financial statements by nature are backward looking whilst capital budgeting and valuations by nature are forward looking and investor would demand market required rate of return on the market value of the capital and not the book value of the capital