On January 1 the total market value of DOS Company was $50 million. During the y
ID: 2756594 • Letter: O
Question
On January 1 the total market value of DOS Company was $50 million. During the year, the company plans to raise and invest, $10 million in new assets. The firm's present market value, optimal capital structure is $10 million debt and $40 million equity. Up to $1 million in new bonds can be sold for $975 each if the maturity is 10 years, the face value is $1000 and the annually paid coupon rate is 11%. Selling any bonds beyond that point will raise only $950 each. Assume that there is no short-term debt. The common stock is currently selling at $45 per share and can be sold to net the company $43 a share after flotation costs, The beta of the firm is 1.5 and the risk-free rate is 8% while the return on the market is 12%. The dividend is $3.38 to be paid next year, and the firm has an annual expected growth rate of 7.5% which is expected to be continuous for the foreseeable future. The bond yields plus risk premium approach assumes that stock earn at least 4% more than the initial rate on debt issued by the company. Retained earnings are projected to be $5 million and the marginal tax rate is 40%.
A. Estimate the current cost of equity by taking an average of the three different methods of estimation?
B. What is the cost of equity after flotation costs?
C. Are there any breakpoints in this WACC, where are they located, and what caused them to occur?
D. How much of the capital budget must be financed by common equity to maintain the optimal capital structure? How much of the new funds are generated by new debt? New stock?
Answer:
Debt 1,925,000
Stock $7,644,445
E. Calculate the two costs of Debt?
Answer: $25000 and $50000
F. Calculate the WACC Both before and after the breakpoints.
Explanation / Answer
Answer : Cost of equity capital
1.) Dividend Forecast approch
K= D/P +g
D = 3.38
P = 45
g = 7.5%
K= 3.38/45+0.075
= 0.15
= 15%
2) Capital Asset Pricing Model Approch
K = Rf + beta (Rm -Rf )
Rf = 8%
beta = 1.5
Rm = 12%
K = 8 +1.5(12-8)
= 14%
3) Cost of Boand yield plus risk premum approch
Boan yield = I(1-t)+{F-P/n}(1-t)/F+P/2
I= 11%
t = 40%
P = 975
F=1000
n = 10 years
Boand yield = 8.20%
K= Long term bond yield +risk premium
= 8.20%+4% = 12.20%
Average of three cost estimation of equity = 15%+14%+12.20%/3
= 13.73%
Answer 2 Cost of capital after Flotaion cost
Flotation cost = 2/45 = 4.44%
cost of capital after flotation cost = 0.1373/1-0.0444
= 0.1436
= 14.36%
Answer C
Break Point in WACC
WACC
Capital Amt (million) Proportion
Equity 40 80%
Debt 10 20%
Total 50 100%
Breaking Point = New Financing from that Source/Proportion of that financing souurce in the capitalstr
= 10/0.2
= 50 Million
Answer (D) :
Cost of Fresh Equit capital
= isue price*Flotation cost
= 8000000*4.4444%
= 355555
Cost of issue of fresh bond
= (Par value - Sale price)*qty+(Par value - Sale price)*qty
= (1000-975)*1000+(1000-950)*1000
= 25000+50000
=75000
Answer 1 (E) Calculation of Cost of Debt
Cost of issue of fresh bond
= (Par value - Sale price)*qty+(Par value - Sale price)*qty
= (1000-975)*1000+(1000-950)*1000
= 25000+50000
=75000
Answer 1 (F) :
WACC After Fund raised
Capital Inst Present Structure New Structure Fund raise Cost New Fund generated Equity 40000000 48000000 8000000 355555 7644445 Debt 10000000 12000000 2000000 75000 1925000 Total 50000000 60000000 10000000 430555 9569445Related Questions
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