Corporate Finance – FIN 622 Assignment # 03 Semester Fall 2007

Question

Following is given the Balance Sheet of XYZ Corporation as on June 30, 2007.

XYZ

Balance Sheet

As on June 30, 2007

Assets

Cash and short-term securities Rs.1,000,000

Accounts Receivables 3,000,000

Inventories 7,000,000

Plant and Equipment 21,000,000

Total Assets Rs 32,000,000

Corporate Finance- FIN 622 Fall 2007 Assignment # 03

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Liabilities and Owners ‘Equity

Bonds Rs. 10,000,000

Preferred stocks 2,000,000

Common Stocks 100,000

Additional paid-in stockholders’ capital 9,900,000

Retained Earnings 10,000,000

Total Rs 32,000,000

Note: The Corporation does not have any short-term liability.

Additional Information:

a. The bonds of the corporation have a face value of Rs.1,000 per bond and

have 10 years to maturity. The coupon rate on these bonds is 8% paid

annually. Current yield to maturity of these bonds is 9%.

b. The corporation has one million common shares outstanding.

c. Preferred stocks of the corporation have a par value of Rs.20 per share, and

its common stocks have a par value of Rs.0.10 per share.

d. The preferred stock currently sells for Rs.15 per share and common stock for

Rs.20 per share.

e. Preferred stocks of the company pay a dividend of Rs.2.00 per share. The

common stocks have a beta of 0.80. The market risk premium is 10%, the risk

free rate is 6% and the firm’s tax rate is 40%.

Required:

1. What is the capital structure of the Corporation based on market values? (10)

2. Calculate the weighted average cost of capital (WACC) of the Corporation

using the market value capital structure. (10)

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Corporate Finance- FIN 622 Fall 2007 Assignment # 03

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Solution:

Requirement # 01:

Capital structure of the Corporation based on market values

Since capital structure is a mix of debt and equity used by a firm, therefore we

calculate the market value of Bonds, Preferred shares and common shares of the

corporation to find the Capital structure based on market values.

1. Bonds

Par value of bonds = Rs.1,000

Book value of bonds = Rs.10,000,000

No. of Bonds outstanding = 10,000,000 / 1,000 = 10,000

Now we calculate present value/bond using discount rate of 9% (the current yield

to maturity on bonds)

Coupon payments = 1,000 × 8% = 80

PV = 80 (PVIFA 9%, 10) + 1,000 (PVIF 9%, 10)

= 80 (6.4177) + 1000 (0.4224)

= 422.4 + 513.416

= 935.816

So market value per bond is Rs.935.816

Market value of outstanding bonds = No. of outstanding bonds × Market value

per bond

Market value of outstanding bonds = 10,000 × 935.816 = Rs.9, 358,160

2. Preferred stocks

Book value of preferred stocks = Rs.20,000,000

Par Value per share = Rs.20

Corporate Finance- FIN 622 Fall 2007 Assignment # 03

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No. Of preferred shares outstanding = Rs.20,000,000 / Rs.20 = 100,000

Market value per share = Rs.15

Market value of outstanding preferred shares = 100,000 ×15 = Rs.1,500,000

3. Common Stocks

No. of Common shares outstanding = 1,000,000

Market value per share = Rs.20 per share

Market value of outstanding common shares = 1,000,000 ×20 = Rs.20,000,000

Capital Structure of the Corporation (Based on market values)

So the required capital structure of the corporation based on current market

values is as follow:

Bonds Rs.9,358,160

Preferred Shares 1,500,000

Common Shares 20,000,000

Total Rs.30,858,160

Requirement # 02:

Weighted Average Cost of Capital of the Corporation.

Capital structure of the Corporation based on market values is (as calculated in

Part.01)

Bonds Rs.9,358,160

Preferred Shares 1,500,000

Common Shares 20,000,000

Total Rs.30,858,160

Corporate Finance- FIN 622 Fall 2007 Assignment # 03

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Weightage of the debt and equity in the capital structure.

Weightage of Debt = XD =

30,858,160

9,358,160 × 100 = 30.33%

Weightage of Preferred Stocks = XP =

30,858,160

1,500,000 × 100 = 4.86%

Weightage of Common Stocks = XC =

30,858,160

20,000,000 × 100 = 64.81%

Market rate of returns on Bonds, Preferred stocks and Common stocks

a. Rate of return on bonds = rD= 9% (Current yield to maturity of bonds)

b. Rate of return on Preferred stocks:

Dividend on preferred stocks = Rs.2.00 per share

Market Price of Preferred Stocks = Rs.15 per share

So rate of return on Preferred Stocks = rP =

15

2 × 100 = 13.33%

c. Rate of return on Common Stocks :

Risk free rate of return = rf = 6%

Market risk premium = rm - rf = 10%

Tax rate = Tx = 40%

Value of Common Stocks beta = β = 0.80

According to CAPM

rC = rf + (rm - rf) × β

Putting values in the above formula we have

rC = 6% + (10%) × 0.80

Corporate Finance- FIN 622 Fall 2007 Assignment # 03

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rC = 6% + 8% = 14%

So return on common stocks is 14%.

Weighted Average Cost of Capital

WACC = XD rD (1 -TX) + XP rP + XC rC

Putting values in the above formula we have

WACC = (30.33%) (9%) (1 - 40%) + (4.86%) (13.33%) + (64.81%) ( 14%)

WACC = (0.3033) (0.09) (0.60) + (0.0486) (0.1333) + (0.6481) (0.14)

WACC = 0.0163782 + 0.006478 + 0.090734

WACC = 0.1136 or 11.36%

So weighted average cost of capital of the corporation is 11.36%.