Part 1: Book Value Balance Sheet (all values in millions) ASSETS: Cash & Equival

Question

Part 1: Book Value Balance Sheet (all values in millions)

ASSETS: Cash & Equivalents = $2, Accounts receivable = $3, Inventories = $7, Plant & equipment = $10, Total = $22

LIABILITIES AND NET WORTH: Bonds:  coupon = 8%, $10.0 Paid annually (maturity = 10 years, current YTM (rd) = 9%), Preferred stock (par value 2.0 = $20 per share), Common stock (par value 0.1 = $0.10), Accounts payable = $9.9, Total = $22

Note the following market factors:  The preferred stock currently sells for $15 per share and the common stock for $20 per share, and there are 1 million shares of common stock outstanding (= $100,000 / 0.1).  Based on a market-value balance sheet, what is the current capital structure of the firm?  (That is, what are the relative weights of debt, preferred stock, and common equity for Rawling, (wd, wps, and wce).  Note that the total market value of the firms equity would be the market price per share times the total number of shares outstanding (or MVEQUITY = Po x # of Shares)

Part 2: If Rawling's preferred stock pays a dividend of $2 per share, the beta of its common stock is 0.8, the market risk premium is 10 percent (i.e., RPm = (rmkt - rrf) = 10%), the risk-free rate (rrf) is 6 percent, and the firms tax rate is 40 percent, what is Rawlings weighted average cost of capital (WACC)?

Explanation / Answer

Part 1

Market Value

Bond = 0.8PVIFA(9%,10) + 10PVIF(9%,10) = $9.3582 Million

Pref stock = $1.50 Million

Common stock = 20* 1 million = $20 Million

Wd = 9.3582/30.8582 = 0.30

Wps = 1.5/30.8582 = 0.05

Wce = 20/30.8582 = 0.65

Part 2

Re = 6 + 10*0.80 = 14%

Rp = 2/20 = 10%

after tax Rd = 8*0.60 = 4.80%

WACC = 14*0.65 + 10*0.05 + 4.8*0.30 = 11.04%

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