Firm A has issued a total of 2 million corporate bonds with a maturity of 10 years and a coupon rate of 5 percent. Coupon payments occur once per year, and the face value of firm A's bonds is $1,000. The current market price for one of the bonds issued by firm A is $830.

 

Firm A plans to issue 8 million equity shares to be traded on public exchanges. Each share is expected to pay a $9 cash dividend after one year, and the firm's CFO forecasts earnings per share of $24 for the year ahead. Firm A's return on equity is 16 percent. Under these conditions, the beta of firm A's common stock is estimated at -0.1, and the beta of firm A's assets is estimated at 0.5.

 

1. Use data from Yahoo! Finance to determine the appropriate market return.  (Or use 10.13% directly)
2. Use data from Yahoo! Finance to determine the appropriate risk-free rate.  (Or use 1.78% directly)
3. What is firm A's financing structure?
4. What is firm A's cost of debt?
5. What is firm A's cost of equity?
6. What is firm A's weighted average cost of capital?
7. What should be the price of one share of firm A's stock?
8. Firm A's CFO suggests issuing another 1 million corporate bonds in addition to the 2 million already issued at the same market price of $830. What effect would this have on the IPO price of firm A's stock?

3. What is firm A's financing structure?
Capital Structure 

Weight of Debt = Market Value of Debt/Total Capital 

Weight of Equity = Market Value of Equity/Total Capital 

Debt 

Market Value = Number of bonds x Bond Price 

= 2Million x 830  

= $1,660 Million 

Market Value of Equity = Number of Common Shares x Stock Price 

ROE = Earning per Share/Value of Stock per Share 

16% = 24/Value of Stock per Share 

Value of stock per Share = 24/16% 

= $150 

Market Value of Equity = 8Million x 150 = $1,200 Million 

Weight of Debt = 1660/(1660+1200)

= 58.0420% 

Weight of Equity = 1200/(1660+1200)

= 41.9580%

Step-by-step explanation

3. What is firm A's financing structure?
Capital Structure 

Weight of Debt = Market Value of Debt/Total Capital 

Weight of Equity = Market Value of Equity/Total Capital 

Debt 

Market Value = Number of bonds x Bond Price 

= 2Million x 830  

= $1,660 Million 

Market Value of Equity = Number of Common Shares x Stock Price 

ROE = Earning per Share/Value of Stock per Share 

16% = 24/Value of Stock per Share 

Value of stock per Share = 24/16% 

= $150 

Market Value of Equity = 8Million x 150 = $1,200 Million 

Weight of Debt = 1660/(1660+1200)

= 58.0420% 

Weight of Equity = 1200/(1660+1200)

= 41.9580% 

 

4. What is firm A's cost of debt?

Cost of Debt = YTM 

Where, from the bond valuation approach

Bond Value = Coupon x [1-(1+YTM)^-n/YTM]+FV/(1+YTM)^n 

830 = 5%*1000*[1-(1+YTM)^-10/YTM]+1000/(1+YTM)^10

830 = 50*[1-(1+YTM)^-10/YTM]+1000/(1+YTM)^10

Using Bootstrap Method 

YTM = 7.4737% 
 

5. What is firm A's cost of equity?

Cost of Equity (using CAPM) 

Re = Rf + (Rm-Rf) x Beta

= 1.78%+(10.13%-1.78%)*-0.1

= 0.95% 

6. What is firm A's weighted average cost of capital?

WACC = (Re x We) + (Rd x Wd) * (1-Tax Rate) 

Where 

Tax Rate 

Asset Beta = Equity Beta/[1+(1-Tax rate) x D/E]

0.5 =-0.1/[1+(1-Tax Rate)*1.3833]

1+(1-Tax Rate)*1.3833 = -0.20

(1-Tax Rate) * 1.3833 = -1.200

1-Tax Rate = -0.8675

Tax Rate = 13.2530% 

WACC = (0.95%*41.9580%)+(7.4737%*58.0420%)*(1-13.2530%)

= 4.1595% 
 

7. What should be the price of one share of firm A's stock?

We can determine the book Value of the stock 

ROE = EPS/Book Value of Stock per Share 

16% = 24/Value of Stock per Share 

Value of Stock per Share = 24/15% 

= $150.00 
 

8. Firm A's CFO suggests issuing another 1 million corporate bonds in addition to the 2 million already issued at the same market price of $830. What effect would this have on the IPO price of firm A's stock?

Current share price = $150

However, when 1 Million additional corporate bonds are issued, the interest paid on the bonds would lower the available EPS. The new Stock price would be as calculated below: 

New EPS = Current EPS - Interest on Debt/Per Share 

Annual Interest payable on the bonds per Common Share Equity = 50*1M/8M 

= $6.25

New EPS = 24-6.25  = 17.75 

Assuming the ROE remains constant 

Stock price = 17.75/16% 

= $110.94 

The share price would reduce to $110.94