Question

you may ude financial calculator and show your entries (i.e., FV = 1000, etc) . show all work and all steps without using an excel.

2. (10 points) You are an outside analyst attempting to estimate the cost of capital for SSK Industrial. You do not know the corporation's target capital structure. However, the balance sheet shows a total of $55 million of long term debt with a coupon rate of 8%. The yield to maturity is 10.70% (before tax) and the total current market value is $50 million. The balance sheets also show the total of common stock and retained earnings is $60 million. The company's stock has a beta of 1.80 and the stock price is $10.00 per share. There are 8 million shares of stock outstanding, and the current risk free rate is 3%. The company recently paid a dividend of $0.70, and they typically pay out about 25% of their earnings in cash dividends. SSK's return on equity is 10% and the expected return on the market is 9.50%. What is your estimate of SSK's weighted average cost of capital if their marginal tax rate is 40%?

Answer 1

Market value of bond = 50 million

Market value of equity = number of shares*price per share = 8 million*10 = 80 million

Total capital = 50 + 80 = 130 million

Weight of debt (wd) = Market value of bond/Total capital = 50/130 = 38.46%

Weight of equity (we) = Market value of equity/Total capital = 80/130 = 61.54%

After-tax cost of debt (rd) = YTM*(1-Tax rate) = 10.70%*(1-40%) = 6.42%

Cost of equity (ke):

Using CAPM, ke = risk-free rate + beta*(market return - risk-free rate) = 3% + 1.8*(9.5%-3%) = 14.70%

Using DDM: growth rate (g) = ROE*retention ratio = 10%*(1-25%) = 7.5%

ke = D0*(1+g)/P0 + g = [0.70*(1+7.5%)/10] + 7.5% = 15.03%

Now, ke can be taken as an average of both values, or either one, depending upon the analysis done. Here, we will take the ke calculated using CAPM.

WACC = (we*ke) + (wd*rd) = (61.54%*14.70%) + (38.46%*6.42%) = 11.52%