Johnson Inc. has the following capital structure (all bonds pay semi-annual coup
ID: 2739739 • Letter: J
Question
Johnson Inc. has the following capital structure (all bonds pay semi-annual coupons and have par value of $1,000):
(1) $500,000 short term bank loan that carries an interest of 3%.
(2) 3,000 bonds with a 7% coupon rate; a current price quote of 84.555; and 25 years to maturity.
(3) 2,000 bonds with an 8% coupon rate; YTM of 9%; and 30 years to maturity.
(4) 4,000 preferred stocks with 6% dividend rate; trading at 80% of par; and a par value of $25.
(5) 50,000 common shares currently trading at $150; and the beta is 0.9
The risk-free rate is 2% and the market risk premium is 8%. The tax rate is 40%.
a) What is the WACC under the current capital structure?
b) If Johnson plans to recapitalize to a debt-to-equity ratio of 1.2 and only use the 30-year bonds and common shares, what will be the WACC under the new capital structure?
c) Johnson needs to raise $1,000,000 for a new project with the new capital structure. The flotation costs on new debt and equity are 5% and 10% respectively. What will be the total cost of the project if 30% of the equity are financed through retained earnings?
Explanation / Answer
a. Total capital amount
1. bank loan = $500,000
2.7% bonds = 3,000,000
3. 8% bonds = 2,000,000
4. preference shares = 100,000
5. common stock = 7,500,000
Total = $ 13,100,000
Ke = 2% + 0.9 * 8% = 9.2%
cost of debt is equal to YTM,
25 year bond YTM = [interest + amortization] / [0.6 s + 0.4 m]
={ 0.07 + [1000-84.555] / 25 } / { 0.6 * 845.55 + 0.4*1000}
= 36.6878 / 907.33 = 4.043%
WACC = [3% * 0.6 * 5/131] + [4.043% * 0.6* 30/131] + [9% * 0.6 * 20/131] + [6% * 1/131] + [9.2% * 75 / 131]
= 6.762%
b. use only 30 year bonds and common stock.,
D / E = 1.2
D = 1.2 * E
D+E = 1
D = 0.5455
E = 0.4545
WACC = 0.5455 * 9% + 0.4545 * 9.2% = 9.1%
c. cost of new equity = D1 / ( P0 - F) + g
D1 = $150 * 9.2% = $13.8
cost of new equity = 13.8 / ( 150 - 15) = 10.22%
cost of debt with flotation cost =[ interest + amortization ] / [ par value + 0.6 * (issue price - par value) ]
={ 80 + (50 / 30) } / {1000 + 0.6 * (950-1000)}
= 81.67 / 970 = 8.42%
Total capital = $1,000,000
30% financed through retained earnings = 300.000
70% by 30 year Debt and new equity = 700,000 in debt by 0.5455 and equity by 0.4545.,
Debt = 381,850
Equity = 318,150
WACC = {318,150 / 1,000,000 * 10.22%} + {381,850 / 1000,000 * 8.42% * 0.6} + {300,000 / 1,000,000 * 9.2%}
= 7.94%
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