question archive Armani is a firm manufacturing perfumes and other cosmetics and it sells its products worldwide
Armani is a firm manufacturing perfumes and other cosmetics and it sells its products worldwide
Subject:FinancePrice:3.86 Bought22
Armani is a firm manufacturing perfumes and other cosmetics and it sells its products worldwide. you are provided the following information –
· The long-term treasury bond rate is 6%.
· The market risk premium is 5.5%
· There are 10 million shares outstanding, trading at $ 40 per share currently; the stock has been traded for only two years. A regression of stock returns against market returns yields a beta of 0.9, with a standard error of 0.8.
· The debt on the balance sheet has two components. The first is traded bonds, with ten years to expiration and a coupon rate of 7%; there are 50,000 bonds outstanding, trading at $ 850 apiece (the face value is $ 1000). The second is $50 million in bank debt, which also has a ten year maturity, and carries an interest rate of 6%. With a market value of $39.5 million
· the marginal tax rate is 40%
a. Estimate the cost of equity for Armani Inc.
b. Estimate the market value of debt and the after-tax cost of debt for Armani Inc.
c. Estimate the cost of capital for this firm using market value weights.
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a)
Risk free rate = 3%
Market risk premium = 5.5%
Beta = 0.9
Cost of equity = Risk free rate + Beta x Market Risk Premium = 3 + 0.9 x 5.5 = 7.95%
b)
Traded Bonds:
Face Value FV = 1000
Present Value PV = 850
Coupon C = FV x 7% = 1000 x 7% = 70
Number of years = 10
Cost of debt = [C + (FV - PV) / t] / (FV + PV)/2 = [70 + (1000 - 850)/10] / [1000 + 850)/2 = 0.09189 or 9.189%
Number of bonds = 50,000
Market value = 50,000 x 850 = 42.5 million
Bank Debt:
Face value = 50 million
Present Value = 35.9 million
Coupon (Interest) C = 50 x 6% = 3 million
Number of years 10
Cost of debt = [3 + (50 - 35.9)/10] / (50 + 35.9) /2 = 0.0943 or 9.43%
Total market value of debt = 35.9 + 42.5 = 78.4 million
Weighted average cost of debt = (42.5 / 78.4) x 9.189 + (35.9 / 78.4) x 9.43 = 9.272%
Tax rate = 40%
After tax cost of debt = 9.272 x (1 - 0.4) = 5.563%
c.
Value of equity = 10,000,000 x 40 = 400 million
Value of debt = 78.4
Total value = 400 + 78.4 = 478.4
WACC = Weight of Debt x after tax cost of debt + weight of equity x cost of equity = (78.4 / 478.4) x 5.563 + (400 / 478.4 ) x 7.95 = 7.559%
