You work for Maverick Manufacturing (MM) and the Vice President of Finance has a

Question

You work for Maverick Manufacturing (MM) and the Vice President of Finance has asked your group to evaluate a firm they are considering acquiring, EDK Industries, a smaller competitor. Your group must estimate the cost of capital so that it can be used to determine the overall value of the acquisition target. From there, your group can determine the intrinsic value of the target firm’s equity shares. MM is fairly conservative and has a target capital structure of 25%, 5%, and 70% for debt, preferred stock, and common equity, respectively. Your boss would like an easily adaptable, attractive spreadsheet model.

Part I. Cost of Capital

Your group identified the following useful information for Maverick Manufacturing:

The book value of equity is $50 million. MM also has 7.5 million shares of common stock outstanding trading at a market price of $21 a share. It is expected that the company will pay a $1.55 dividend per share next year, after which, dividends will grow at a constant 4% rate. The common stock has a beta of 1.75; the market risk premium is 5.5% and the risk-free rate is 2%.

Moreover, there are 1 million shares of 4% preferred stock outstanding at a market price of $28 per share (assume par value = $50).

Maverick Manufacturing issued 30 year bonds 3 years ago with a coupon rate of 8%. The bonds are currently trading at 95% of par and there are 85,000 bonds outstanding. They have no other interest-bearing debt. The bonds pay interest semiannually.

The tax rate is 35%

Objective: Calculate the firm’s weighted average cost of capital.

Explanation / Answer

Answer: Market value of equity=7.5 million shares*$21=$157.5+50=207.5 million

Market value of preference shares=1 million shares*$28=$28 million

Market value of bonds=85000 bonds*95%*100=$8.075 million

Ke=2%+1.75*5.5%

=11.625%

Kp=4%*50/28=7.143%

Kb=

N=54

PMT=40

PV=950

R=4.24%

YTM=8.48%

After tax cost of debt=8.48%(1-0.35)=5.512%

Particulars Cost (%) Market value (in millions) Weight WACC Bonds 5.512 8.075 0.033152 0.182734 Preference shares 7.143 28 0.114954 0.821119 Equity 11.625 207.5 0.851894 9.903264 Total 243.575 1 10.90712

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