I included the answers to the questions. I just need help understanding how to g
ID: 2756225 • Letter: I
Question
I included the answers to the questions. I just need help understanding how to get to the answers so please show your work. Thank you!
16. What is the firm’s cost of debt? ---> ANS: 12%
17. What is the required return on common stock and on preferred stock? ---> ANS: 12.17%, 5.63%
18. What portion of the firm is financed with debt? ---> ANS: 42%
19. What is the weighted average cost of capital for this firm? ---> ANS: 10.06%
Use the following information to answer questions 16-19 Balance Sheet (All values are based on current market values) Current Assets Fixed Assets $2,000,000 $3,000,000 Debt Preferred Stock Common Stocks2,650,427 Total Liabilities and Owner's Equity $5,000,000 $2,099,573 $250,000 Total Assets $5,000,000 The firm's debt consists of 15% coupon bonds that pay coupons semiannually and mature in 20 years. There are 1713 bonds outstanding. There are 6250 shares of preferred stock outstanding selling in the market for $40 each. The preferred stock pays an annual dividend of $2.25. The current market price of the firm's common stock is $25.75. The firm just paid out annual dividends of $1.50 to common stockholders. It is expected that dividends will grow by 6% each year, forever. The firm's marginal tax rate is 34%.Explanation / Answer
Answer to 16:
Cost of debt:
Given data,
Market value of Debt = $2099573
Number of bonds = 1713
Market value per bond = Total market value / Number of bonds
= 2099573 / 1713
= $1225.67
Coupon rate = 15%
Let face value of bond be $1000 and yield be x
Interest per annum = 1000 * 15% = $150
Market value of bond = NPV of all future cash flows
This implies,
(PVAF (x%, 20yrs) * 102.7125) + (PVF (x%,20yrs) * 1000) = $1225.67
By applying trial and error method,
At 12%, Market value = (7.46944 * 150) + (0.102666 * 1000) = 1120.416 + 102.666 = 1223.082
Therefore cost of debt is 12% (approx.)
Cost of debt = 12%
Answer to 17:
Required return on common stock:
Given data,
Dividend of last year, D0 = $1.5
Growth rate, g = 6%
Market Value, P0 = $25.75
Let return on common stock be r
P0 = (D0 (1+g) / (r - g)
25.75 = (1.5(1+0.06) / (r – 0.06))
25.75 = 1.59 / (r – 0.06)
r – 0.06 =1.59 / 25.75
r = 0.1217
r = 12.17 %
Required return on common stock = 12.17%
Required return on preferred stock:
Given data,
Dividend, D = $2.25
Market value, P0 = $40
Let return on preferred stock be r
P0 = D / r
r = D / P0
r = 2.25 / 40
r = 0.05625
r = 5.625%
Return on preferred stock = 5.63% (approx.)
Answer to 18:
Portion of firm that is financed by debt:
Debt = $2099573
Total Liabilities & Owners Equity = $5000000
Portion of debt = Debt / Total liabilities & Owners Equity
= 2099573 / 5000000
= 0.4199146
= 42% (approx.)
Portion of firm that is financed with debt =42%
Answer to 19:
Weighted Average Cost of Capital:
Type of capital
Value
Cost
Wt
Cost * Wt
Common Stock
2650427
12.17%
0.53
6.4501
Preferred Stock
250000
5.63%
0.05
0.2815
Debt
2099573
7.92% (12(1-0.34))
0.42
3.3264
5000000
10.058
Weighted Cost of Capital = 10.06%
Type of capital
Value
Cost
Wt
Cost * Wt
Common Stock
2650427
12.17%
0.53
6.4501
Preferred Stock
250000
5.63%
0.05
0.2815
Debt
2099573
7.92% (12(1-0.34))
0.42
3.3264
5000000
10.058