1. Rubberman Corporation, a manufacturer of consumer plastic products, is evalua

Question

1. Rubberman Corporation, a manufacturer of consumer plastic products, is evaluating its capital structure. The balance sheet of the company is as follows (in millions):
Assets Liabilities
Fixed Assets $4000 Debt $2,500
Current Assets $1000 Equity $2,500
In addition, you are provided the following information:

(a) The debt is in the form of long term bonds, with a coupon rate of 10%. The bonds are currently rated AA and are selling at a yield of 12% (the market value of the bonds is 80% of the face value).

(b) The firm currently has 50 million shares outstanding, and the current market price is $80 per share. The firm pays a dividend of $4 per share and has a price/earnings ratio of 10.

(c) The stock currently has a beta of 1.2. The six-month Treasury bill rate is 8%.

(d) The tax rate for this firm is 40%.

I. What is the debt/equity ratio for this firm in book value terms? in market value terms?

II. What is the debt/(debt+equity) ratio for this firm in book value terms? in market value terms?

III. What is the firm's after-tax cost of debt?

IV. What is the firm's cost of equity?

V. What is the firm's current cost of capital?

Explanation / Answer

I) Debt equity ratio in book value = Debt book value / Equity book value = 2500 / 2500 = 1

Debt equity ratio in market value = Debt market value / Equity market value = (2500*.8) / (50*80) = 0.5

II) Debt ratio in book value = Debt book value/ (Debt book value + Equity book value)

= 2500 / (2500 + 2500) = 0.5

  Debt ratio in market value = Debt market value/ (Debt market value + Equity market value)

= (2500*.8) / (2500*.8 + 50*80) = 1/3 OR 33.33%

III) After tax cost of debt = Yield * (1 - Tax rate) = 12%* (1 - .40) = 7.2%

IV) Cost of equity = Rf + (Rm - Rf) * Beta = 8% + (12% - 8%)*1.2 = 12.80%

Note: In absence of any specific market return, bond yield is considered as market return.

V) Current cost of capital of firm = Kd * Wd + Ke * We

= 7.2%*.5 + 12.80%*.5

= 10%

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