ACME Inc. is a multinational conglomerate corporation providing a wide range of

Question

ACME Inc. is a multinational conglomerate corporation providing a wide range of goods and services to its customers. As part of its budgeting process for the next year, it has several projects under consideration so it must decide which projects should receive capital budgeting investment funds for this year. As part of the financial analysis department, you have been given several projects to evaluate. However, before you can determine the appropriate valuations of these projects, you need to determine the weighted average cost of capital for the firm since it is used as a threshold of acceptability for projects. Remember that management has a preference in using the market values of the firm’s capital structure and believes it current structure (target weight/market weight) is optimal.

Market Values of Capital

1. The company has 60,000 bonds with a 30-year life outstanding, with 15 years until maturity. The bonds carry a 10 percent semi-annual coupon, and are currently selling for $874.78.

2. You also have 100,000 shares of $100 par, 9% dividend perpetual preferred stock outstanding. The current market price is $90.00.

3. The company has 5 million shares of common stock outstanding with a currently price of $17.00 per share. The stock exhibits a constant growth rate of 10 percent. The last dividend (D0) was $.65.

4. The risk-free rate is currently 6 percent, and the rate of return on the stock market as a whole is 13 percent. Your stock’s beta is 1.22.

5. Your firm only uses bonds for long-term financing.

6. Your firm’s federal + state marginal tax rate is 40%.

Depreciation Schedule

Modified Accelerated Cost Recovery System (MACRS)

Ownership Year 5-Year Investment Class Depreciation Schedule

1 20%

2 32%

3 19%

4 12%

5 11%

6 6%

Total = 100%

Find the costs of the individual capital components:

long-term debt (before tax and after tax)

preferred stock

average cost of retained earnings (avg. of Capital Asset Pricing Model & Gordon Growth Model/Constant Growth Model)

Determine the target percentages for the optimal capital structure, and then compute the WACC. Carry weights to a minimum of four decimal places.

Please explain in laymans terms and write out how each answer was derived please.

Explanation / Answer

No of Bonds 60000 Nper 15 Semi annual payment 10% Current price 874.48 n=15*2 30 r=10%/2 5% Intrest per period I=1000*5% 50 tax rate= 40% Face value= 1000 874.48=50*(PVA1$,r%,30)+1000*(PV1$,r%,30) By solving this r=5.9% Annual YTM =5.9%*2 11.8% After tax cost of Debt 11.8%(1-.4) 7.08% Cost of preferred stock=D/P0 =9/90 10.0% Cost of retained earning No of shares 50,00,000 Current price 17 Growth rate 10% D0             0.65 Growth rate Ke=D0*(1+g)/p0+g Ke=.65*(1+10%)/17+10% 14.21% CAPM method rf+beta*(mr-rf) =6%+1.22*(13%-6%) 14.54% Average cost of equity =(14.21%+14.54%)/2 14.38% WACC Qty Rate Value Weight Debt        60,000 874.78     5,24,86,800 0.358304 Preferred Stock    1,00,000 90        90,00,000 0.061439 Equity 50,00,000 17     8,50,00,000 0.580257 14,64,86,800                 1 WACC=.358304*7.08%+.061439*10%+.580257*14.38% 11.50% Cost of the debt derived by finding out present value of the inflow which a bond holder will have by keeping the bond Cost of preference shareholder has been find out by simple ROI Cost of equity is the average of under two method WACC is find out by mulipying weight of each security to respective cost and adding them is the total cost of the firm

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