FIN 500: Case Study 2 Assignment

If
you use Excel to calculate some portions of this assignment (which is fine), be
sure the final report is printable and readable in standard format
(i.e., on an 8.5 x 11 page). Please print out your Excel file (in its exact
form) prior to sending it to be sure it is well organized, formatted properly,
and doesn’t print out with multiple blank pages or separated columns .

1.
At
the current time Warren Industries can issue 15-year, $1,000 par-value bonds
paying annual interest at a 12% coupon rate. As a result of current interest
rates, the bonds can be sold for $1,010 each. Flotation costs of $30 per bond
will be incurred in the process (which implies that f = 2.97%, or 0.0297 in
decimal form) and the firm is in a 40% tax bracket.

(a)
Find
the net proceeds from the sale of each bond for Warren Industries.

(b)
Calculate
the before-tax and the after-tax cost of debt for Warren
Industries.

2.
Drywall
Systems, Inc., is presently in discussions with its investment bankers
regarding the issuance of new bonds. The investment banker has informed the
company that different maturities will carry different coupon rates and sell at
different prices. Drywall Systems must choose among several alternatives. In
each case, the bonds will have a $1,000 par value and flotation costs will be
$30 per bond. This implies that the firm will net $970 per bond, before
the adjustment for the premium (+) or discount (-). The company is taxed at a
rate of 40%. Calculate the after-tax costs of financing with each of the
following alternatives.

Alternative	Coupon Rate	Time to Maturity	Premium (+) or Discount (-)
A	9%	16 years	+ $250
B	7%	5 years	+ $50
C	6%	7 years	Par
D	5%	10 years	– $75

3. Gem
Systems has recently issued preferred stock. The stock has a 12% annual
dividend based on a par value of $100 per share. The stock is currently selling
for $97.50 per share in the secondary market (so that P_o = $97.50). Finally,
flotation costs of $2.50 must be paid for each new share Gem Systems issues.

(a) Calculate
the cost of preferred stock based on the outstanding issue, given the current
market price.

(b) If
Gem Systems sells a new issue of preferred stock carrying a par value of $100
but with an annual dividend of 10% of par, what is the cost of this newly
issued preferred stock if the firm nets $90.00 per share after flotation costs?

4. Calculate
the cost of preferred stock (r_PS) for each of the following:

Preferred Stock	Par Value	Current Price (Po)	Flotation Cost	Annual Dividend (% of Par)
A	$100	$101	$9.00	11%
B	$40	$38	$3.50	8%
C	$35	$37	$4.00	$5.00
D	$30	$26	5% of par	$3.00
E	$20	$20	$2.50	9%

5. JPM
Corporation common stock has a beta of 1.2. The risk-free rate is 6%, and the
market return is 11%.

(a) Derive
the risk premium on JPM common stock.

(b) Determine
JPM’s cost of common equity using the CAPM.

6. Reynolds
Textiles wants to measure its cost of common equity. The firm’s stock is
currently selling for $57.50 per share. The firm expects to pay a $3.40
dividend at the end of 2011 (so assume that

D₁ = $3.40 for purposes
of calculation). The dividends for the last 5 years are as follows:

Year Dividend

2010 $3.10

2009 $2.92

2008 $2.60

2007 $2.30

2006 $2.12

After
incurring flotation costs, Reynolds Textiles expects to net $52 per share on a
new issue.

(a) Determine
the growth rate of dividends (g).

(b) By
applying the constant-growth valuation model, determine the cost of retained
earnings common equity (r_s).

(c) By
applying the constant-growth valuation model, determine the cost of
newly-issued common equity (r_e).

7. Brite
Lighting Corporation wants to investigate the effect on its cost of capital
based on the rate at which the company is taxed. The firm wishes to maintain a
capital structure of 30% debt, 10% preferred stock, and 60% common stock. The
cost of financing with retained earnings is 14% (i.e., r_s = 14%),
the cost of preferred stock financing is 9% (r_ps = 9%), and the before-tax
cost of debt is 11% (r_d = 11%). Calculate the weighted average cost
of capital (WACC) given the tax rate assumptions in parts (a) to (c) below.

(a) Tax
rate = 40%.

(b) Tax
rate = 35%.

(c) Tax
rate = 25%.

8. Westerly
Manufacturing has compiled the information shown in the following table:

Source of Capital	Book Value	Market Value	After-tax Cost
Long-Term Debt	$4,000,000	$3,840,000	6.0%
Preferred Stock	$40,000	$60,000	13.0%
Common Stock Equity	$1,060,000	$3,000,000	17.0%
Totals	$5,100,000	$6,900,000

(a) Calculate
the firm’s weighted average cost of capital (WACC) using book value weights.

(b) Calculate
the firm’s weighted average cost of capital (WACC) using market value weights.

(c) Compare
your answers found in parts (a) and (b) and briefly explain the differences. Other
things equal, would you recommend that Westerly Manufacturing rely on its book
value weights or market value weights in determining its WACC?

9. To help finance a major expansion, Delano Development Company sold a noncallable bond several years ago that now has 15 years to maturity. This bond has a 10.25% annual coupon, paid semiannually, it sells at a price of $1,025, and it has a par value of $1,000. If Delano’s tax rate is 40%, what component cost of debt should be used in the WACC calculation?

10. Roxie Epoxy’s balance sheet shows a total of $50 million long-term debt with a coupon rate of 8.00% and a yield to maturity of 7.00%. This debt currently has a market value of $55 million. The balance sheet also shows that that the company has 20 million shares of common stock, and the book value of the common equity (common stock plus retained earnings) is $65 million. The current stock price is $8.25 per share; stockholders’ required return, rs, is 10.00%; and the firm’s tax rate is 40%. Based on market value weights, and assuming the firm is currently at its target capital structure, what WACC should Roxie use to evaluate capital budgeting projects?

11. Bruner Breakfast Foods’ (BBF) balance sheet shows a total of $20 million long-term debt with a coupon rate of 8.00% (assume each bond to have a maturity value, M, of $1,000). The yield to maturity on this debt is 10.00%, and the debt has a total current market value of $18 million. The balance sheet also shows that that the company has 10 million shares of stock, and total of common equity (common stock plus retained earnings) is $30 million. The current stock price is $4.50 per share, and stockholders’ required rate of return, rs, is 12.25%. The company recently decided that its target capital structure should have 50% debt, with the balance being common equity. The tax rate is 40%. Calculate WACCs based on target, book, and market value capital structures (Note: I am asking for three (3) separate WACC values here).