question archive Use the following information about Extreme Ltd
Use the following information about Extreme Ltd
Subject:FinancePrice:3.87 Bought7
Use the following information about Extreme Ltd.’s capital structure to answer the questions below;
Extreme’s capital structure is made up of:
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CAPITAL STRUCTURE |
|
|
DEBT |
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EQUITY |
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- Extreme Ltd. has 120,000 bonds outstanding with a face value of $100 each. These bonds have 3 years to maturity and pay an annual coupon of 6%. Extreme’s statutory corporate tax rate is 30%.
Moody’s Corporation is one of a big ratings agency which has given Extreme Ltd. a debt rating of AAA. The following table shows the risk premium available in the market based on debt ratings:
|
Debt rating |
Risk premium |
|
AAA |
5.0% |
|
AA |
6.5% |
|
BBB |
7.2% |
|
BB |
7.5% |
- The risk free rate is 1%.
- Extreme Ltd. has issued 7 million preference shares, which pay an annual dividend per share of $0.25. They are currently trading at $2 each.
- Extreme Ltd. has issued 10 million ordinary shares, which are currently trading at $4 each. Shareholders are to receive a dividend of $0.60 per share in the current year, and this dividend is estimated to grow at a constant rate of 3% in perpetuity.
NOTE: Round all dollar amounts to the nearest dollar and all percentages to two decimal places.
1. What is Extreme's after?tax cost of debt?
2. What is the value of Extreme's bonds?
3. What is the market value of Extreme's preference shares?
4. What is Extreme's cost of preference shares?
5. What is the market value of Extreme's ordinary shares?
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Answer:
1. Extreme's after?tax cost of debt = cost of debt*(1 - tax rate)
cost of debt is the market required rate of return on the bonds.
market required rate of return = risk-free rate + market risk premium on AAA rated bonds
Extreme's debt is AAA rated.
market required rate of return = 1% + 5% = 6%
Extreme's after?tax cost of debt = 6%*(1 - 0.30) = 6%*0.70 = 4.20%
2. value of Extreme's bonds = no. of bonds outstanding*market price per bond
annual coupon rate and market required rate of return are equal as 6%. when a bond's coupon rate and market required rate of return are same then that bond will trade at face value (which is $100 in this case) in the market.
we can also use financial calculator for calculation of market price of bond with below keystrokes.
N = maturity = 3; I/Y = market required rate of return = 6%; PMT = annual coupon = $100*6% = $6; FV = face value = $100 > CPT = compute > PV = market price of the bond = $100
value of Extreme's bonds = 120,000*$100 = $12,000,000
3. market value of Extreme's preference shares = no. of preference shares outstanding*market price per share
market value of Extreme's preference shares = 7,000,000*$2 = $14,000,000
4. cost of preference shares = annual dividend/current price of share = $0.25/$2 = 0.125 or 12.50%
5. market value of Extreme's ordinary shares = no. of ordinary shares outstanding*market price per share
market value of Extreme's ordinary shares = 10,000,000*$4 = $40,000,000
