FPC, Inc
Subject:FinancePrice:3.86 Bought35
FPC, Inc. issued 10-year $1,000-par bonds five years ago. They carried a coupon rate of 6%. The coupons were paid annually. Currently the bond is selling for $883.40.4 PX The firm's stock price has risen to $21.50 recently. It was $10 when issued. The firm's return on equity (ROE) is 20%, and its dividend payout ratio is 40%. It just paid $1 annual dividend recently. The dividend is expected to grow at a constant rate. Assume the firm is in the 30% (combined) tax bracket. Many specialized consulting firms have a long-term debt to total asset ratio of approximately 40 percent on average. It is considered to be the optimal debt to firm value ratio.
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| 1. To find WACC of the firm: |
| After-tax cost of bonds , kd : |
| Using the formula to find the current selling price of the bond, ie |
| Current Price=Present value of all its future coupons+PV of face value to be recd. At maturity--- both discounted at its YTM(ie. Yield To Maturity--- which is the before-tax cost of the bond) |
| ie. Price=(Pmt.*(1-(1+r)^-n)/r)+(FV/(1+r)^n) |
| Where, Price= the current selling price, given as $ 883.40 |
| Pmt.=The annual $ coupon ie. 1000*6%= $ 60 |
| r= the annual YTM---- to be found out---- ?? |
| n= no.of annual coupons, pending to maturity, ie. 5 |
| FV=Face value, ie. $ 1000 |
| now, plugging in all these values in the above formula, |
| 883.40=(60*(1-(1+r)^-5)/r)+(1000/(1+r)^5) |
| Solving for r, we get the annual before-tax YTM/Cost of the bond as |
| 8.9975% |
| So, |
| the after-tax cost of the bond= |
| Before-tax cost*(1-Tax rate) |
| ie.8.9975%*(1-30%)= |
| 6.30% |
| Cost of common stock, ke |
| First we will find the growth rate of dividends, g |
| g= Return on Equity*Retention Ratio |
| ie.g= ROE*RR |
| ie.g=ROE*(1-Dividend pay-out ratio) |
| ie.g=20%*(1-40%)= |
| 12% |
| According to Gordon's constant growth model of dividends, |
| Cost of equity=(Next dividend/Current stock price)+Growth rate of dividends |
| ie. Ke=(D1/P0)+g |
| where, ke---- needs to be found out----- ?? |
| D1=D0*(1+g), ie. 1*(1+12%)= $ 1.12 |
| P0= Current stock price, ie. $ 21.50 |
| g= found above as 12% or 0.12 p.a. |
| now, plugging in all these values in the above formula, |
| ie ke=(1.12/21.50)+0.12 |
| 17.21% |
| Now the WACC of the firm, |
| given the debt/total assets ratio for these types of firms ,as 40% |
| WACC=(Wt.e*ke)+(wt.d*kd) |
| ie. (60/100*17.21%)+(40%*6.30%)= |
| 12.85% |
| (Answer) |
| 2. Capital market data helps us to know the current selling price prevailing in the market, with which we can estimate the market interest rate, or real cost of the future cash flows of the stock/bond . |
| For example, In the given problem, we found the actual cost of holding the bond, till maturity , by discounting the cash flows at its YTM only---- which was made possible by having a knowledge about its market price . |
| Same is the case with stocks also.We related dividend to the stock's current market price only, to calculate its cost. |
| 3.Factors affecting cost of capital |
| a. Mangement's preference in holding certain proportions of various sources of capital, such as equity, preference or debt |
| b. Its repaying capacity & also its attitude towards repayment---whether to hold long-term Or short-term, will decide if it's going to be equity/ debt respectively. |
| c.Attitude to pay dividends or retain profits |
| d. Market interest rates, if very high, may fetch very low issue proceeds on debt |
| e. Interest paying capacity , also decides debt levels & hence cost of capital |
| Factors affecting cash flow estimates |
| a.Demand for products & revenue generated |
| b. Working capital requirements, that are dependent on sales estimates |
| c.Levels of various cost estimates |
| d. Effect of Tax & its implications |
| e. Salvage cash flow |
| f. level of fixed asset spending |
