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Question 2

Robert Bernard is an investment analyst employed to JMMB. He was requested to assess the capital structure of Worthy Park Estate Rums and has provided the following information:

Preferred Stock:

13 000 shares of 8 percent preferred stock issued at $100.00 per share. Current market price is

$80 per share.

Common Stock:

60 000 shares outstanding, selling for $105 per share. The current treasury bill rate is 12% and

the stocks beta is 1.50. The expected rate of return on the average stock in the market is 16%.

Debt

The firm can borrow funds at 23% interest per year. Assume that the tax rate is 30%.

a. Using the information above to calculate the firms WACC if the target capital structure comprises 40% debt, 20% preferred stock and 40% common stock. (13 marks)

b. If the beta of the stock was two (2) and the firms capital structure was modified to 40% debt, 10% preferred stock, and 50% common, what is the firms WACC? (6 marks)

c. The firm is expected to pay a year end dividend of $10.00 per share at year end and its flotation cost if 10%. Investors have projected an expected growth rate of 8% per annum

i. What is the cost of retained earnings using the discounted cash flow approach?

ii. Calculate the cost of issuing new common stock.

Preferred shares Rp = D P(1- Flotation cost)

Debt K_d after taxes = K_d (1 tax rate)

Cost of common stock = E(r_e) = Rf + (R_m - Rf)

WACC = (W_d R_d)+ (W_pR_p) +W_eR_e)

r = D₁/ P_o +g

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