Cook Wares has a target debt ratio (debt/value) of 60%. The 10-year bonds have a
ID: 2654522 • Letter: C
Question
Cook Wares has a target debt ratio (debt/value) of 60%. The 10-year bonds have a coupon rate of 8.3% (paid annually) and currently trade for $1125 per bond. The tax rate is 30%. They have the following information on their stock (You will need to fill in the blanks):
Current EPS
Current Dividend
Return on Equity
Current Price
Payout Rate = Div/EPS
Growth = Retention x ROE
a) Calculate the weighted average cost of capital.
b) The firm has a 3-year planning period. The firm expects cash flows of $6M next year, and the cash flows will initially grow at the growth rate. After year 3, they estimate that the cash flows will start to grow at 2% indefinitely. Find the value of the operations.
c) The firm has $8M in cash, $2M in debt and 5M shares outstanding. Find the share price.
Current EPS
Current Dividend
Return on Equity
Current Price
Payout Rate = Div/EPS
Growth = Retention x ROE
Explanation / Answer
(b)
After year-3, cash flows will grow at 2% indefinitely, so this is a perpetual cash flow.
Present value of this perpetual cash flow at year-3 = $6M / 0.02 = $300M
Present value of this perpetual cash flow at year-1 = $300M / (1.02)3 = $282.7 M
So,
Value of operations = [$6M / 1.02] + [$6M / (1.02)2] + [$6M / (1.02)3] + $282.7 M
= $[5.88 + 5.77 + 5.65 + 282.7]M = $300M
(c) Total Assets = $8M (Cash)
Total liabilities = $2M (Debt)
Equity = Totala ssets - Total liabilities = $6M
So, price per share = Equity / Number of outsanding shares = $6M / 5M = $1.2 per share
(a) Annual coupon payment = $1,000 x 8.3% = $83
Current market price of bond = $1,125
So, Cost of debt = ($83 / $1,125) x (1 - 0.30) = 5.16%
Proportion of debt in WACC = 60% x 5.16% = 3.096%
However, cost of equity cannot be calculated. To calculate cost of equity we need the value of dividend paid, since:
Cost of equity = [Dividend / Share Price] + Growth rate.
We have the values of share price [Calculated in part (c) as $1.20] and growth rate (Given 2%, Part (b)). But dividend paid is a necessary input that is not provided.
Also note, to calculate Current EPS, ROE & retention rate, we need to know the Current Net Income (Earnings) of the company. This value is not provided. Payout Ratio requires Dividend amount to be provided, but this information is missing.
If you provide these values against comment to this answer, I shall calculate these components and respond.