Question

On January 1, the total market value of the Farrah Fowler (FF) Company was $100 million. The firm’s present market value capital structure, show below, is considered to be optimal. Assume that there is no short-term debt.
Debt = $20,000,000
Common Equity = $80,000,000
Total capital = $100,000,000
New bonds will have a 6.25 percent coupon rate and be sold at par (thus YTM = coupon rate). Common stock is currently selling for $75 per share. Stockholders’ required rate of return is estimated to be 11 percent, consisting of a dividend yield of 4 percent and an expected growth rate of 7 percent. The marginal tax rate is 25 percent.
a. What is the FF’s market value capital structure?
b. Assume that there is sufficient cash flow such that FF can maintain its target capital structure without issuing additional shares of equity. What is the WACC?
c. Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock. Qualitatively speaking (no computations required), what will happen to the WACC?

Answer 1

a)

0.8000 Capital strucuture weight of equity Capital strucuture weight of debt 0.2000

b)

Cost % Market value 11.00% $ 80 Weight 0.8000 WACC (Cost %*Weights) 8.80% Cost of equity (rs) Bonds 20 0.2000 0.94% 4.69% $ =6.25%*(1-25%) Total $ 100 1.0000 Weighted average cost of capital (WACC) 9.74%

c) New stocks will have a cost of equity more than the cost of retained earnings. So, using new shares is capital structure will increase WACC. *Please rate thumbs up