Assignment 1
Iqra Javaid – 46032
Submitted to Muhammad Zeeshan
Q No.1
Reactive Industries has the following capital structure. Its corporate tax rate is 35 percent. What is
its WACC?
Security Market value required return
Debt $ 20 million 6%
Preferred stock 10 8%
Common stock 50 12%
Solution:
Security Market Value w Required return Weighted cost
Debt 20 20/80 = 0.25 6% (1-0.35) = 3.9% 0.0098
Preferred Stock 10 0.125 8% 0.01
Common Stock 50 0.625 12% 0.075
80 1 0.0948 = 9.48%
WACC = 9.48%
A company has issued 10 year bond a year ago at par value with a coupon rate of 9%, paid
annually. Today the bond is selling at 1150. Firm is in the tax bracket of 40%. Company has
preferred stock on which dividend is fixed $ 4 and market price of preferred stock is $ 45.
Company issued common stock, dividend currently paid $2 which is expected to grow at a rate of
4% and stock is selling at $ 25. If company is planning to invest in a project at a ratio of 40:20:40.
What should be weighted average cost of capital of this project?
Solution:
i. BOND
rd = ?
n=9
CR = 9%
Price = 1150
−n
1−( 1+YTM )
Price=CP ( YTM ) + Face Value (1+YTM )
−n
−9
1− ( 1+YTM )
1150=90 ( YTM )+1000 ( 1+YTM )−9
YTM = rd = 0.0672 or 6.72%
ii. STOCKS
ZERO GROWTH
rps = ?
D=4
Price = 45
D
P=
r
4
45=
r
rps = 0.0889 or 8.89%
CONSTANT GROWTH
rcs = ?
Dο = 2
Pο = 25
g = 4%
D₁
P ο= D₁ = Dο(1+g)
r −g
Dο(1+ g)
P ο=
r −g
2(1+ 4 %)
25=
r−4 %
rcs = 0.1232 or 12.32%
WACC
Security w Required return Weighted cost
Debt 0.4 6.72% (1- 0.4) = 0.0403 0.0161
Preferred Stock 0.2 8.89% 0.0178
Common Stock 0.4 12.32% 0.0492
1 0.0831 = 8.31%
WACC = 8.31%
Q No. 2
David Ortiz Motors has a target capital structure of 40 percent debt and 60 percent equity. The
yield to maturity on the company’s outstanding bonds is 9 percent, and the company’s tax rate is
40 percent. Ortiz’s CFO has calculated the company’s WACC as 9.96 percent. What is the
company’s cost of equity capital?
Solution:
Security w Required return Weighted cost
Debt 40% 9% (1-0.4) = 0.054 0.0216
Equity 60% 13% 0.078
1 0.0996 = 9.96%
rc = 0.078 / 0.6 = 13%
Q No. 3
Sidman Products stock is currently selling for $60 a share. The firm is expected to earn $5.40 per
share this year and to pay a year-end dividend of $3.60.
a. If investors require a 9 percent return, what rate of growth must be expected for Sidman?
b. If Sidman reinvests earnings in projects with average returns equal to the stocks expected
rate of return, what will be next year’s EPS?
Solution:
a. CONSTANT GROWTH
Pο = 60
D₁ = 3.60
r = 9%
g=?
D₁
P ο=
r −g
3.60
60=
9 %−g
g = 0.03 or 3%
b. D₁ = Dο(1+g)
EPS₂ = EPS₁ (1+g)
= 5.40 (1+ 0.03)
EPS₂ = 5.562
Q No. 4
On January 1, the total market value of the Tysseland Company was $60 million. During the year,
the company plans to raise and invest $30 million in new projects. The firm’s present market value
capital structure, shown below, is considered to be optimal. Assume that there is no short-term
debt.
Debt $30,000,000
Common Equity 30,000,000
Total capital $60,000,000
New bonds will have an 8 percent coupon rate, and they will be sold at par. Common stock is
currently selling at $30 a share. Stockholders required rate of return is estimated to be 12 percent,
consisting of a dividend yield of 4 percent and an expected constant growth rate of 8 percent. (The
next expected dividend is $1.20, so $1.20/$30 = 4 %.) The marginal corporate tax rate is 40
percent.
a. To maintain the present capital structure, how much of the new investment must be
financed by common equity?
b. Assume that there is sufficient cash flow such that Tysseland can maintain its target capital
structure without issuing additional shares of equity. What is the WACC?
Suppose now that there is not enough internal cash flow and the firm must issue new shares of
stock. Qualitatively speaking, what will happen to the WACC?
Solution:
a. The company’s capital structure is optimal. The capital structure based on 50% debt and
50% equity. The total market value of the firm is 60million out of which 30 million is
financed through equity,
then the weight of equity = 30,000,000/60,000,000
= 0.5
= 0.5(30,000,000)
Common Equity needed= 15,000,000
b.
Security Market Value w Required return Weighted cost
Debt 30,000,000 0.5 8% (1-0.4) = 0.048 0.024
Common Equity 30,000,000 0.5 0.12 0.06
60,000,000 1 0.084 = 8.4%
c. If new project finance from equity the weight of equity will increase and WACC will also
increase.
