The Gifts R’ Us Inc. (GRU) is expecting a substantial jump in sales and needs to
ID: 2754471 • Letter: T
Question
The Gifts R’ Us Inc. (GRU) is expecting a substantial jump in sales and needs to add $6 million in assets. Its current balance sheet is shown below. Its current operations are expected to add $1,750,000 to retained earnings during the coming year
Its current debt, originally issued at par, has a 6% coupon paid semiannually. It has 12 years to maturity and has a market price of $847.53. The current preferred stock (40,000 shares outstanding) carries a dividend of $7.50 per share and is selling in the market at $87 per share. Its common stock (700,000 shares outstanding) is selling in the market at $30 per share. The company expects to pay a common stock dividend of $2.50 per share next year. The dividends are expected to grow at 6% per year for the foreseeable future.
The company can sell new common stock at current market price with a flotation cost of 5%, new preferred stock with a dividend of $8 per share to net $91 per share, and new semiannual coupon bonds with a par value of $1,000 and maturity of 20 years with a coupon rate of 9% to net $1,047.69.
Calculate GRU's weighted average cost of capital assuming that the current capital structure is optimal and answer the following questions? The company's overall tax rate is 40%.
1. What percent of total new financing must come from equity funds?
2. What percent of equity funds must come from new equity?
3. What is the after-tax cost of debt?
4. What is the after-tax cost of preferred stock?
5. What is the average after-tax cost of all equity funds?
6. What is the weighted average cost of capital?
Cash 750,000 Accounts Payable 2,000,000 Accounts Receivable 3,000,000 Notes Payable 1,500,000 Inventory 1,500,000 Current Liabilities 3,500,000 Current Assets 5,250,000 Long-term Debt (6%) 7,000,000 Net Fixed Assets 15,000,000 Preferred Stock 2,000,000 Common Stock and Retained Earnings 7,750,000 Total Assets 20,250,000 Total Liabilities + Equity 20,250,000Explanation / Answer
1)
Current capital structure:
Market Value of Debt = 7000000/1000 * 847.53
Market Value of Debt = 5932710
Market Value of preferred stock = 40000 * 87
Market Value of preferred stock = 3480000
Market Value of common stock = 700000 * 30
Market Value of common stock = 21,000,000
Total Market Value = 30,412,710
Weight of Debt = 5932710/30412710 = 19.51%
Weight of prefered stock = 3480000/30412710 = 11.44%
Weight of Equity =21000000/30412710 = 69.05%
Answer
69.05% of total new financing must come from equity funds
2)
Equity Fund Required = 6000000*69.05%
Equity Fund Required = $ 4,143,000
Retained Earning is increased = $ 1,750,000
New Equity = 4143000-1750000
New Equity = $ 2,393,000
New Equity Percentage of Equity fund = 2393000/4143000
New Equity Percentage of Equity fund = 57.76%
Answer
57.76% of equity funds must come from new equity
3)
Before tax cost of debt = rate(nper,pmt,pv,fv)*2
Nper (indicates the semi annual period) = 20*2 = 40
PV (indicates the price) = -1047.69
PMT (indicate the semi annual payment) = 1000*9%*1/2 = 45
FV (indicates the face value) = 1000
Rate (indicates YTM) = ?
Before tax cost of debt = rate(40,45,-1047.69,1000)*2
Before tax cost of debt = 8.50%
After tax cost of debt = Before tax cost of debt*(1-tax rate)
After tax cost of debt = 8.50*(1-40%)
After tax cost of debt = 5.10%
4)
After-tax cost of preferred stock = Dividend/Current Share Price
After-tax cost of preferred stock = 8/91
After-tax cost of preferred stock = 8.79%
5)
Cost of Retained Earning = Expected Dividend/Current Share Price + growth rate
Cost of Retained Earning = 2.5/30 + 6%
Cost of Retained Earning = 14.33%
Cost of New Equity = Expected Dividend/(Current Share Price - Flotation Cost) + growth rate
Cost of New Equity = 2.5/(30 - 5%*30) + 6%
Cost of New Equity = 14.77%
Average after-tax cost of all equity funds = Weight of Retained Earning of total Equity *Cost of Retained Earning + Weight of new equity * cost of new equity
Average after-tax cost of all equity funds = (1-57.76%)*14.33 + 57.76%*14.77
Average after-tax cost of all equity funds = 14.58%
6)
WACC = Weight of Equity* Cost of Equity + Weight of Preferred Stock* Cost of Preferred Stock + Weight of Debt* After Tax cost of Debt
WACC = 69.05%*14.58 + 11.44%*8.79 + 19.51%*5.1
WACC = 12.07%
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