29 Jun uestion 1. At the current time Warren Industries
uestion
1. At the current time Warren Industries can issue 15-year, $1,000 par-value bonds paying annual interest at a 12% coupon rate. As a result of current interest rates, the bonds can be sold for $1,010 each. Flotation costs of $30 per bond will be incurred in the process (which implies that f = 2.97%, or 0.0297 in decimal form) and the firm is in a 40% tax bracket
(a) Find the net proceeds from the sale of each bond for Warren Industries.
(b) Calculate the before-tax and the after-tax cost of debt for Warren Industries.
2. Drywall Systems, Inc., is presently in discussions with its investment bankers regarding the issuance of new bonds. The investment banker has informed the company that different maturities will carry different coupon rates and sell at different prices. Drywall Systems must choose among several alternatives. In each case, the bonds will have a $1,000 par value and flotation costs will be $30 per bond. This implies that the firm will net $970 per bond, before the adjustment for the premium (+) or discount (-). The company is taxed at a rate of 40%.
Calculate the after-tax costs of financing with each of the following alternatives.
Alternative Coupon Rate Time to Maturity Premium (+) or Discount (-)
3. Gem Systems has recently issued preferred stock. The stock has a 12% annual dividend based on a par value of $100 per share. The stock is currently selling for $97.50 per share in the secondary market (so that Po = $97.50). Finally, flotation costs of $2.50 must be paid for each new share Gem Systems issues. (a) Calculate the cost of preferred stock based on the outstanding issue, given the current market price.
4. Calculate the cost of preferred stock (rPS) for each of the following:
Preferred Stock Par Value Current Price (Po) Flotation Cost Annual Dividend (% of Par)
A $100 $101 $9.00 11%
B $40 $38 $3.50 8%
C $35 $37 $4.00 $5.00
D $30 $26 5% of par $3.00
E $20 $20 $2.50 9%
5. JPM Corporation common stock has a beta of 1.2. The risk-free rate is 6%, and the market return is 11%.
(a) Derive the risk premium on JPM common stock.
(b) Determine JPM’s cost of common equity using the CAPM.
6. Reynolds Textiles wants to measure its cost of common equity. The firm’s stock is currently selling for $57.50 per share. The firm expects to pay a $3.40 dividend at the end of 2011 (so assume that D1 = $3.40 for purposes of calculation). The dividends for the last 5 years are as follows: Year Dividend 2010 $3.10 2009 $2.92 2008 $2.60 2007 $2.30 2006 $2.12 After incurring flotation costs, Reynolds Textiles expects to net $52 per share on a new issue.
(a) Determine the growth rate of dividends (g).
(b) By applying the constant-growth valuation model, determine the cost of retained earnings common equity (rs).
(c) By applying the constant-growth valuation model, determine the cost of newly-issued common equity (re).
7. Brite Lighting Corporation wants to investigate the effect on its cost of capital based on the rate at which the company is taxed. The firm wishes to maintain a capital structure of 30% debt, 10% preferred stock, and 60% common stock. The cost of financing with retained earnings is 14% (i.e., rs = 14%), the cost of preferred stock financing is 9% (rps = 9%), and the before-tax cost of debt is 11% (rd = 11%). Calculate the weighted average cost of capital (WACC) given the tax rate assumptions in parts (a) to (c) below.
(a) Tax rate = 40%.
(b) Tax rate = 35%.
(c) Tax rate = 25%.
Westerly Manufacturing has compiled the information shown in the following table:
Source of Capital Book Value Market Value After-tax Cost
Long-Term Debt $4,000,000 $3,840,000 6.00%
Preferred Stock $40,000 $60,000 13.00%
Common Stock Equity $1,060,000 $3,000,000 17.00%
Totals $5,100,000
$6,900,000
(a) Calculate the firm’s weighted average cost of capital (WACC) using book value weights.
(c) Compare your answers found in parts (a) and (b) and briefly explain the differences. Other things equal, would you recommend that Westerly Manufacturing rely on its book value weights or market value weights in determining its WACC?
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