The company has currently 20 000 shares outstanding. The book value per share is
ID: 2796673 • Letter: T
Question
The company has currently 20 000 shares outstanding. The book value per share is $20. The stock is currently trading at the P/B ratio of 2.0; P/E= 14 and EV/EBITDA=7.5. It is also known that the risk free rate is 2%, the beta of the stock is 2.0 and the market risk premium over risk free rate is equal to 5%. You may assume that the marginal tax rate on profits is 25%.
The company is going to issue 6 000 coupon bonds with the par value of $100 per bond, 6% annual coupon rate. Similar bonds currently trade at 4% yield level . The bonds will mature exactly 8 years from now.
Find:
a) Cost of debt and equity
b) The shares of debt and equity in capital structure
c) Find WACC and interpret your result?
Explanation / Answer
a) Cost of debt (Kd) = Yield currently prevailing in market = 4% (Coupon is just the interest rate paid)
Using CAPM, Cost of Equity (Ke) = RF + x Risk Premium = 2% + 2 x 5% = 12%
b) Market Value of Equity = No of shares x market value per share = 20,000 x (20 x 2) = $800,000
Market Value of 1 bond = cdf(8,4%) x coupon + df(8,4%) x maturity value
= 6.73 x $6 + 0.73 x $100
=$113.40
Market Value of Debt = 6000 x 113.40 = $680,400
Capital Structure:
Share of Equity = 800,000 / 1480,400 = 54%
Share of Debt = 680,400 / 1480,400 = 46%
c) WACC = (54% x 12%+ 46% x 4%) = 8.32%
This is average cost of capital employeed is 8.32%