Problem 1
Amalgated Properties Limited (APL)
needs $2,000,000 for it’s capital budget projects
this year. APL has the following capital structure, which it considers optimal (based on
market values).
Debt
20%
Preferred Shares
15%
Common Shares
65%
APL has $1,000 par value bonds outstanding with a 9% coupon rate and 8 years to
maturity. Issusing costs would be $20 per bond and the bonds could be sold at a discount
of $30 per bond. Preferred shares with a $80 par value could be sold to the public at a
price of $75 per share and s dividend of 10%, however flotation costs would be $2 per
share. APL paid a dividend of $4 per share last year and earnings and dividends are
expected to grow at a constant rate of 8% per year. APL’s stock currently sells at a price
of $65 per share and aftertax flotation costs would be $2 per share. APL has a marginal
tax rate of 40% and this year, they expect to have $1,200,000 available from internally
generated funds available for capital budgeting purposes. Calculate APL’s marginal cost
of capital (WACC).
Problem 2
A firm currently has $10 million (par value) in debt outstanding in the form of bonds,
which currently trade at 104% of par value. The bonds have a remaining term to maturity
of 7 years. They have a coupon rate of 10%. The firm also has preferred shares
outstanding; they have 1 million preferred shares outstanding, which pay an annual
dividend of $0.40 each. The current market price of the firm’s preferred is $5. The firm
has 2 million common shares outstanding which trade at a price of $12 each.
The firm’s common shares have a correlation with the overall stock market of 0.35. The
standard deviation of returns on the firm’s stock is 0.4, and for the market overall the
standard deviation is 0.1. The yield on Treasury bills is 4% and the expected risk
premium on the market is 5.5%.
To issue new bonds would involve flotation costs (after tax) equal to 2% of the par value
issued. To issue new shares (whether preferred or common) would involve flotation costs
equal to 5% of the current price.
The firm has enough cash on hand to finance any projects which it wants to, and its tax
rate is 34%.
(a)
What is the weighted average cost of capital of the firm?
(b)
Assume that there is a change in the investment environment, and
investors suddenly start believing that the stock market is riskier than they thought it
was before. Because of this, the risk premium on the market increases. How and why
might this affect the firm’s investment decisions (i.e. what projects they decide to
invest in)?
Problem 3
A firm is financed with a combination of debt and common equity. The market value of
the firm’s debt is $150 million. The yield to maturity of the firm’s debt is 12%. The firm
has 20 million common shares outstanding, with a total market value of $500 million. It
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View Full Documentis expected that next year’s dividend on the shares will be $3 and that dividends will
grow at a rate of 4% per year after that. To borrow new money would involve no flotation
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 Spring '11
 Mishra
 Finance, Corporate Finance, Cost Of Capital, Debt, Net Present Value, Firm, Weighted average cost of capital

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