Dinklage Corp. has 5 million shares of common stock outstanding. The current sha
ID: 2760763 • Letter: D
Question
Dinklage Corp. has 5 million shares of common stock outstanding. The current share price is $71, and the book value per share is $6. The company also has two bond issues outstanding. The first bond issue has a face value of $65 million, a coupon of 6 percent, and sells for 96 percent of par. The second issue has a face value of $45 million, a coupon of 7 percent, and sells for 105 percent of par. The first issue matures in 21 years, the second in 5 years. (a) What are the company's capital structure weights on a book value basis? (b) What are the company’s capital structure weights on a market value basis? (c) Which are more relevant, the book or market value weights?
Explanation / Answer
Solution:
1) To compute the book value of equity :
no of shares * book value of shares = 5 million * 6 per share
hence = 30million
to compute the book value of debt :
face value of bond = 65+45 = 110 million
hence the total book value = 30 +110 = 140 million and the weights are :
equity = 30/140 = 21.42%
and debt = 100%-21.42% = 78.58%
2) company's capital structure on market basis:
market value of equity = market price * no of shares outstanding free float in the market :
= 5 million * 71 = 355million
to compute the market value of debt :
face value * percent of selling = 65*.96+45*1.05 = 109.65 is the market value of debt
hence the total market value = market value of equity + debt
= 355+109.65 = 464.65million
the weightage of equity = 355/464.65n = 76.40%
weightage of debt = 100% - 76.40 = 23.60%
3) The most relevant is the market value weights i would like to explain with an example:
Assume a firm issued capital at $10 per equity share 5 years back. Current market value of the share is $30 and book value is $18 and market required rate of return is 20%. The investors (existing and new) of the company will expect return on $30 and not $18. Let us see how a rational investor will behave.
New Investor: He can buy the share of the company at $30 from the market. If the firm returns 20% on book value i.e. $3.6. The new investor will calculate his percentage of gain 12% (3.6/30) which is far less than 20%. Why 30 dollar because the investment by him is 30 and not 10 or 18.
Existing Investor: Since, market required rate of return is 20% and return on investment at current prices is only 12%, better situation for existing investor would be to sell off the securities at $30 and invest in other securities giving more than 12% return. The existing investor will exit from the investment considering it an overpriced stock and invest at securities which are underpriced or appropriately priced by the market.
Conclusion: The market value weights are appropriate compared to book value weights.