You are given the following for Cardinal & Cardinal, Inc. Their tax rate is 34%. The firm is in need of $5 million dollars in external funds. Your bond advisor suggests that new bond issues can be lower than the current yield to maturity by 1.5% .
Existing capital structure:
• C&C Debt: 4,000 Eight percent (8%) coupon bonds outstanding. The par value is $1000 and they mature in ten years. They are currently selling for $1010 and make semiannual payments.
• C&C Equity: 50,000 shares outstanding. The common stock is currently selling for $62 per share. The beta for the company is 1.10.
• C&C Preferred Stock: 9,000 shares of 4% preferred stock with a par value of $100, and is currently selling for $60 per share.
• Market Information: The risk of the market is 8% and the risk-free rate is 3%. The industry debt-equity ratio is 33%. The flotation rate for debt is 3% and for equity it is 4%.
Calculate the existing weighted average cost of capital, Calculate the new cost of capital when the $5M in new funds is added. Show your calculations of the capital structure, assess the capital structure, compare recommend the new funding choice impacts on capital structure, and determine the firm’s new weighted average cost of capital
To calculate the existing weighted average cost of capital (WACC), we need to determine the cost of debt, cost of equity, and the weights of each component in the capital structure.
1. Cost of debt:
The cost of debt can be found using the yield to maturity (YTM) of the existing bonds. The YTM of the existing bonds is lower by 1.5% compared to the current yield, which is 8%.
YTM = 8% - 1.5% = 6.5%
2. Cost of equity:
The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM):
Cost of equity = Risk-free rate + Beta * (Market risk premium)
Market risk premium = Market risk - Risk-free rate = 8% - 3% = 5%
Cost of equity = 3% + 1.10 * 5% = 8.5%
3. Weights of each component:
To calculate the weights, we need to determine the market values of debt, equity, and preferred stock.
Market value of debt = Number of bonds * Price per bond = 4,000 * $1,010 = $4,040,000
Market value of equity = Number of shares * Price per share = 50,000 * $62 = $3,100,000
Market value of preferred stock = Number of shares * Price per share = 9,000 * $60 = $540,000
Total market value of the firm = Market value of debt + Market value of equity + Market value of preferred stock
= $4,040,000 + $3,100,000 + $540,000
= $7,680,000
Weight of debt = Market value of debt / Total market value of the firm = $4,040,000 / $7,680,000 = 0.526
Weight of equity = Market value of equity / Total market value of the firm = $3,100,000 / $7,680,000 = 0.403
Weight of preferred stock = Market value of preferred stock / Total market value of the firm = $540,000 / $7,680,000 = 0.071
4. Calculate the WACC:
WACC = (Weight of debt * Cost of debt) + (Weight of equity * Cost of equity) + (Weight of preferred stock * Cost of preferred stock)
WACC = (0.526 * 6.5%) + (0.403 * 8.5%) + (0.071 * Cost of preferred stock)
= 3.419% + 3.429% + (0.071 * Cost of preferred stock)
Now, to calculate the new cost of capital when $5 million in new funds is added, we need to adjust the capital structure.
1. Assess the capital structure:
The current capital structure shows that the weight of debt is higher compared to equity and preferred stock. This indicates that the firm relies more on debt financing.
2. Compare and recommend the new funding choice impacts on capital structure:
To find the new capital structure, we need to adjust the market values of debt and equity when $5 million in new funds is added. Let's assume that the entire $5 million is added to equity.
New market value of debt = Market value of debt = $4,040,000
New market value of equity = Market value of equity + $5,000,000 = $3,100,000 + $5,000,000 = $8,100,000
New market value of preferred stock = Market value of preferred stock = $540,000
New total market value of the firm = New market value of debt + New market value of equity + New market value of preferred stock
= $4,040,000 + $8,100,000 + $540,000
= $12,680,000
New weight of debt = New market value of debt / New total market value of the firm = $4,040,000 / $12,680,000 = 0.319
New weight of equity = New market value of equity / New total market value of the firm = $8,100,000 / $12,680,000 = 0.639
New weight of preferred stock = New market value of preferred stock / New total market value of the firm = $540,000 / $12,680,000 = 0.042
3. Determine the firm's new weighted average cost of capital (WACC):
The cost of debt remains the same, but the weights have changed. The cost of preferred stock is not provided, so let's assume it remains the same at 4%.
New WACC = (New weight of debt * Cost of debt) + (New weight of equity * Cost of equity) + (New weight of preferred stock * Cost of preferred stock)
New WACC = (0.319 * 6.5%) + (0.639 * 8.5%) + (0.042 * 4%)