The following table gives the current balance sheet for Travellers Inn Inc. (TII), a company that was formed by merging a number of regional motel chains. Travellers Inn (Millions of Dollars) The following facts also apply to TII. (1) The long-term debt consists of 29,412 bonds, each having a 20-year maturity, semiannual payments, a coupon rate of 7.6%, and a face value of $1,000. Currently, these bonds provide investors with a yield to maturity of 11.8%. If new bonds were sold, they would have an 11.8% yield to maturity. (2) TII’s perpetual preferred stock has a $100 par value, pays a quarterly dividend per share of $2, and has a yield to investors of 10%. New perpetual preferred stock would have to provide the same yield to investors, and the company would incur a 3.85% flotation cost to sell it. (3) The company has 3.8 million shares of common stock outstanding, a price per share = P 0 = $20, dividend per share = D 0 = $1, and earnings per share = EPS 0 = $5. The return on equity (ROE) is expected to be 10%. (4) The stock has a beta of 1.6%. The T-bond rate is 6%, and RP M is estimated to be 5%. (5) TII’s financial vice president recently polled some pension fund investment managers who hold TII’s securities regarding what minimum rate of return on TII’s common would make them willing to buy the common rather than TII bonds, given that the bonds yielded 11.8%. The responses suggested a risk premium over TII bonds of 3 percentage points. (6) TII is in the 25% federal-plus-state tax bracket. Assume that you were recently hired by TII as a financial analyst and that your boss, the treasurer, has asked you to estimate the company’s WACC under the assumption that no new equity will be issued. Your cost of capital should be appropriate for use in evaluating projects that are in the same risk class as the assets TII now operates. Based on your analysis, answer the following questions. a. What are the current market value weights for debt, preferred stock, and common stock? ( Hint: Do your work in dollars, not millions of dollars. When you calculate the market values of debt and preferred stock, be sure to round the market price per bond and the market price per share of preferred to the nearest penny.) b. What is the after-tax cost of debt? c. What is the cost of preferred stock? d. What is the required return on common stock using CAPM ? e. Use the retention growth equation to estimate the expected growth rate. Then use the expected growth rate and the dividend growth model to estimate the required return on common stock. f. What is the required return on common stock using the own-bond-yield-plus-judgmental-risk-premium approach? g. Use the required return on stock from the CAPM model, and calculate the WACC.

Question

Want to see more full solutions like this?

Answer 1

Textbook Question

Chapter 9, Problem 17P

The following table gives the current balance sheet for Travellers Inn Inc. (TII), a company that was formed by merging a number of regional motel chains.

Travellers Inn (Millions of Dollars)

Chapter 9, Problem 17P, The following table gives the current balance sheet for Travellers Inn Inc. (TII), a company that

The following facts also apply to TII.

(1) The long-term debt consists of 29,412 bonds, each having a 20-year maturity, semiannual payments, a coupon rate of 7.6%, and a face value of $1,000. Currently, these bonds provide investors with a yield to maturity of 11.8%. If new bonds were sold, they would have an 11.8% yield to maturity.
(2) TII’s perpetual preferred stock has a $100 par value, pays a quarterly dividend per share of $2, and has a yield to investors of 10%. New perpetual preferred stock would have to provide the same yield to investors, and the company would incur a 3.85% flotation cost to sell it.
(3) The company has 3.8 million shares of common stock outstanding, a price per share = P₀ = $20, dividend per share = D₀ = $1, and earnings per share = EPS₀ = $5. The return on equity (ROE) is expected to be 10%.
(4) The stock has a beta of 1.6%. The T-bond rate is 6%, and RP_M is estimated to be 5%.
(5) TII’s financial vice president recently polled some pension fund investment managers who hold TII’s securities regarding what minimum rate of return on TII’s common would make them willing to buy the common rather than TII bonds, given that the bonds yielded 11.8%. The responses suggested a risk premium over TII bonds of 3 percentage points.
(6) TII is in the 25% federal-plus-state tax bracket.

Assume that you were recently hired by TII as a financial analyst and that your boss, the treasurer, has asked you to estimate the company’s WACC under the assumption that no new equity will be issued. Your cost of capital should be appropriate for use in evaluating projects that are in the same risk class as the assets TII now operates. Based on your analysis, answer the following questions.

a. What are the current market value weights for debt, preferred stock, and common stock? (Hint: Do your work in dollars, not millions of dollars. When you calculate the market values of debt and preferred stock, be sure to round the market price per bond and the market price per share of preferred to the nearest penny.)
b. What is the after-tax cost of debt?
c. What is the cost of preferred stock?
d. What is the required return on common stock using CAPM?
e. Use the retention growth equation to estimate the expected growth rate. Then use the expected growth rate and the dividend growth model to estimate the required return on common stock.
f. What is the required return on common stock using the own-bond-yield-plus-judgmental-risk-premium approach?
g. Use the required return on stock from the CAPM model, and calculate the WACC.

a.

Expert Solution

Summary Introduction

To determine: The market value weights of debt, common stock and preferred stock.

Answer to Problem 17P

The market value weights of debt are 20%, common stock is 76% and preferred stock is 4%.

Explanation of Solution

Determine the market value weights of debt, common stock and preferred stock

Excel Spreadsheet:

Financial Management: Theory & Practice, Chapter 9, Problem 17P , additional homework tip 1

Excel Workings:

Financial Management: Theory & Practice, Chapter 9, Problem 17P , additional homework tip 2

Therefore, the market value weights of debt are 20%, common stock is 76% and preferred stock is 4%.

b.

Expert Solution

Summary Introduction

To determine: The after-tax cost of debt.

Answer to Problem 17P

The after-tax cost of debt is 8.85%.

Explanation of Solution

Determine the after-tax cost of debt

Aftertax Cost of Debt=[Pretax Cost of Debt×(1−Tax Rate)]=[11.80%×(1−25%)]=0.0885 or 8.85%

Therefore, the after-tax cost of debt is 8.85%.

c.

Expert Solution

Summary Introduction

To determine: The cost of preferred stock.

Answer to Problem 17P

The cost of preferred stock is 10.40%.

Explanation of Solution

Determine the cost of preferred stock

Cost of Preferred Stock=[Annual Preferred DividendStock Price×(1−Flotation Costs)]=[$100×10%$100×(1−3.85%)]=[$10$96.15]=0.104004 or 10.40%

Therefore, the cost of preferred stock is 10.40%.

d.

Expert Solution

Summary Introduction

To determine: The required return on common stock using CAPM.

Answer to Problem 17P

The required return on common stock using CAPM is 14%.

Explanation of Solution

Determine the required return on common stock using CAPM

Cost of Common StockCAPM=[Riskfree Rate+Beta×Market Risk Premium]=[6%+1.6×5%]=14%

Therefore, the required return on common stock using CAPM is 14%.

e.

Expert Solution

Summary Introduction

To determine: The required return on common stock using dividend growth model.

Answer to Problem 17P

The required return on common stock using dividend growth model is 13.40%.

Explanation of Solution

Determine the payout ratio

Payout Ratio=[Dividend per shareEarnings per share]=[$1$5]=20%

Therefore, the payout ratio is 20%.

Determine the growth rate

Growth Rate=[ROE×(1−Payout Ratio)]=[10%×(1−20%)]=8%

Therefore, the growth rate is 8%.

Determine the required return on common stock using dividend growth model

Cost of Common StockDividend Growth=[(Dividends×(1+Growth Rate)Stock Price)+Growth Rate]=[($1×(1+8%)$20)+8%]=[0.054+0.08]=13.40%

Therefore, the required return on common stock using dividend growth model is 13.40%.

f.

Expert Solution

Summary Introduction

To determine: The required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach.

Answer to Problem 17P

The required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach is 14.80%.

Explanation of Solution

Determine the required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach

Cost of Common StockBond Yield Judgemental=[Bond Yield+Risk Premium Percentage Points]=[11.8%+3%]=14.80%

Therefore, the required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach is 14.80%.

g.

Expert Solution

Summary Introduction

To determine: The WACC.

Answer to Problem 17P

The WACC is 12.83%.

Explanation of Solution

Determine the WACC

WACC=[((WeightDebt×RateDebt)×(1−Tax))+(WeightPreferred Stock×RatePreferred Stock)+(WeightCommon Stock×RateCommon Stock)]=[((20%×8.85%))+(4%×10.40%)+(76%×14%)]=[1.77%+0.42%+10.64%]=12.83%

Therefore, the WACC is 12.83%.

Want to see more full solutions like this?

Subscribe now to access step-by-step solutions to millions of textbook problems written by subject matter experts!

Students have asked these similar questions

The table below shows a book balance sheet for the Wishing Well Motel chain. The company's long-term debt is secured by its real estate assets, but it also uses short-term bank loans as a permanent source of financing. It pays 13% interest on the bank debt and 10% interest on the secured debt. Wishing Well has 10 million shares of stock outstanding, trading at $82 per share. The expected return on Wishing Well's common stock is 21%. (Table figures in $ millions.) Cash and marketable securities 24 Bank loan $4 100 270 Accounts payable Accounts receivable 130 170 Current liabilities Inventory 50 400 Current assets 320 Long-term debt Equity Real estate 1,800 1,440 Other assets 120 400 $ 2,240 $ 2,240 Total Total Calculate Wishing Well's WACC. Assume that the book and market values of Wishing Well's debt are the same. The marginal tax rate is 21%. (Do not round intermediate calculations. Enter your answer as a percent rounded to 1 decimal place.) Weighted-average cost of capital

The table below shows a book balance sheet for the Wishing Well Motel chain. The company's long-term debt is secured by its real estate assets, but it also uses short-term bank loans as a permanent source of financing. It pays 15% interest on the bank debt and 13% interest on the secured debt. Wishing Well has 10 million shares of stock outstanding, trading at $90 per share. The expected return on Wishing Well's common stock is 19%. (Table figures in $ millions.) Cash and marketable securities Accounts receivable Inventory Current assets Real estate Other assets Total $ Weighted-average cost of capital $ 90 250 50 $ 390 % 2,200 100 2,690 Bank loan Accounts payable Current liabilities Long-term debt Equity Total $ 350 150 $ 500 Calculate Wishing Well's WACC. Assume that the book and market values of Wishing Well's debt are the same. The marginal tax rate is 21%. Note: Do not round intermediate calculations. Enter your answer as a percent rounded to 1 decimal place. 1,790 400 $ 2,690

The table below shows a book balance sheet for the Wishing Well Motel chain. The company's long-term debt is secured by its real estate assets, but it also uses short-term bank loans as a permanent source of financing. It pays 13% interest on the bank debt and 11% interest on the secured debt. Wishing Well has 10 million shares of stock outstanding, trading at $85 per share. The expected return on Wishing Well's common stock is 18%. (Table figures in $ millions.) $ 130 $ 270 Bank loan Cash and marketable securities 170 Accounts payable Accounts receivable 290 $ 440 Inventory Current liabilities 50 $ 2,400 470 Current assets Long-term debt Equity 2,150 Real estate 400 120 Other assets $ 2,990 $ 2,990 Total Total Calculate Wishing Well's WACC. Assume that the book and market values of Wishing Well's debt are the same. The marginal tax rate is 21%. (Do not round intermediate calculations. Enter your answer as a percent rounded to 1 decimal place.) Weighted-average cost of capital

Answer 2

Textbook Question

Chapter 9, Problem 17P

The following table gives the current balance sheet for Travellers Inn Inc. (TII), a company that was formed by merging a number of regional motel chains.

Travellers Inn (Millions of Dollars)

Chapter 9, Problem 17P, The following table gives the current balance sheet for Travellers Inn Inc. (TII), a company that

The following facts also apply to TII.

(1) The long-term debt consists of 29,412 bonds, each having a 20-year maturity, semiannual payments, a coupon rate of 7.6%, and a face value of $1,000. Currently, these bonds provide investors with a yield to maturity of 11.8%. If new bonds were sold, they would have an 11.8% yield to maturity.
(2) TII’s perpetual preferred stock has a $100 par value, pays a quarterly dividend per share of $2, and has a yield to investors of 10%. New perpetual preferred stock would have to provide the same yield to investors, and the company would incur a 3.85% flotation cost to sell it.
(3) The company has 3.8 million shares of common stock outstanding, a price per share = P₀ = $20, dividend per share = D₀ = $1, and earnings per share = EPS₀ = $5. The return on equity (ROE) is expected to be 10%.
(4) The stock has a beta of 1.6%. The T-bond rate is 6%, and RP_M is estimated to be 5%.
(5) TII’s financial vice president recently polled some pension fund investment managers who hold TII’s securities regarding what minimum rate of return on TII’s common would make them willing to buy the common rather than TII bonds, given that the bonds yielded 11.8%. The responses suggested a risk premium over TII bonds of 3 percentage points.
(6) TII is in the 25% federal-plus-state tax bracket.

Assume that you were recently hired by TII as a financial analyst and that your boss, the treasurer, has asked you to estimate the company’s WACC under the assumption that no new equity will be issued. Your cost of capital should be appropriate for use in evaluating projects that are in the same risk class as the assets TII now operates. Based on your analysis, answer the following questions.

a. What are the current market value weights for debt, preferred stock, and common stock? (Hint: Do your work in dollars, not millions of dollars. When you calculate the market values of debt and preferred stock, be sure to round the market price per bond and the market price per share of preferred to the nearest penny.)
b. What is the after-tax cost of debt?
c. What is the cost of preferred stock?
d. What is the required return on common stock using CAPM?
e. Use the retention growth equation to estimate the expected growth rate. Then use the expected growth rate and the dividend growth model to estimate the required return on common stock.
f. What is the required return on common stock using the own-bond-yield-plus-judgmental-risk-premium approach?
g. Use the required return on stock from the CAPM model, and calculate the WACC.

a.

Expert Solution

Summary Introduction

To determine: The market value weights of debt, common stock and preferred stock.

Answer to Problem 17P

The market value weights of debt are 20%, common stock is 76% and preferred stock is 4%.

Explanation of Solution

Determine the market value weights of debt, common stock and preferred stock

Excel Spreadsheet:

Financial Management: Theory & Practice, Chapter 9, Problem 17P , additional homework tip 1

Excel Workings:

Financial Management: Theory & Practice, Chapter 9, Problem 17P , additional homework tip 2

Therefore, the market value weights of debt are 20%, common stock is 76% and preferred stock is 4%.

b.

Expert Solution

Summary Introduction

To determine: The after-tax cost of debt.

Answer to Problem 17P

The after-tax cost of debt is 8.85%.

Explanation of Solution

Determine the after-tax cost of debt

Aftertax Cost of Debt=[Pretax Cost of Debt×(1−Tax Rate)]=[11.80%×(1−25%)]=0.0885 or 8.85%

Therefore, the after-tax cost of debt is 8.85%.

c.

Expert Solution

Summary Introduction

To determine: The cost of preferred stock.

Answer to Problem 17P

The cost of preferred stock is 10.40%.

Explanation of Solution

Determine the cost of preferred stock

Cost of Preferred Stock=[Annual Preferred DividendStock Price×(1−Flotation Costs)]=[$100×10%$100×(1−3.85%)]=[$10$96.15]=0.104004 or 10.40%

Therefore, the cost of preferred stock is 10.40%.

d.

Expert Solution

Summary Introduction

To determine: The required return on common stock using CAPM.

Answer to Problem 17P

The required return on common stock using CAPM is 14%.

Explanation of Solution

Determine the required return on common stock using CAPM

Cost of Common StockCAPM=[Riskfree Rate+Beta×Market Risk Premium]=[6%+1.6×5%]=14%

Therefore, the required return on common stock using CAPM is 14%.

e.

Expert Solution

Summary Introduction

To determine: The required return on common stock using dividend growth model.

Answer to Problem 17P

The required return on common stock using dividend growth model is 13.40%.

Explanation of Solution

Determine the payout ratio

Payout Ratio=[Dividend per shareEarnings per share]=[$1$5]=20%

Therefore, the payout ratio is 20%.

Determine the growth rate

Growth Rate=[ROE×(1−Payout Ratio)]=[10%×(1−20%)]=8%

Therefore, the growth rate is 8%.

Determine the required return on common stock using dividend growth model

Cost of Common StockDividend Growth=[(Dividends×(1+Growth Rate)Stock Price)+Growth Rate]=[($1×(1+8%)$20)+8%]=[0.054+0.08]=13.40%

Therefore, the required return on common stock using dividend growth model is 13.40%.

f.

Expert Solution

Summary Introduction

To determine: The required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach.

Answer to Problem 17P

The required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach is 14.80%.

Explanation of Solution

Determine the required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach

Cost of Common StockBond Yield Judgemental=[Bond Yield+Risk Premium Percentage Points]=[11.8%+3%]=14.80%

Therefore, the required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach is 14.80%.

g.

Expert Solution

Summary Introduction

To determine: The WACC.

Answer to Problem 17P

The WACC is 12.83%.

Explanation of Solution

Determine the WACC

WACC=[((WeightDebt×RateDebt)×(1−Tax))+(WeightPreferred Stock×RatePreferred Stock)+(WeightCommon Stock×RateCommon Stock)]=[((20%×8.85%))+(4%×10.40%)+(76%×14%)]=[1.77%+0.42%+10.64%]=12.83%

Therefore, the WACC is 12.83%.

Want to see more full solutions like this?

Subscribe now to access step-by-step solutions to millions of textbook problems written by subject matter experts!

Answer 3

Textbook Question

Chapter 9, Problem 17P

The following table gives the current balance sheet for Travellers Inn Inc. (TII), a company that was formed by merging a number of regional motel chains.

Travellers Inn (Millions of Dollars)

Chapter 9, Problem 17P, The following table gives the current balance sheet for Travellers Inn Inc. (TII), a company that

The following facts also apply to TII.

(1) The long-term debt consists of 29,412 bonds, each having a 20-year maturity, semiannual payments, a coupon rate of 7.6%, and a face value of $1,000. Currently, these bonds provide investors with a yield to maturity of 11.8%. If new bonds were sold, they would have an 11.8% yield to maturity.
(2) TII’s perpetual preferred stock has a $100 par value, pays a quarterly dividend per share of $2, and has a yield to investors of 10%. New perpetual preferred stock would have to provide the same yield to investors, and the company would incur a 3.85% flotation cost to sell it.
(3) The company has 3.8 million shares of common stock outstanding, a price per share = P₀ = $20, dividend per share = D₀ = $1, and earnings per share = EPS₀ = $5. The return on equity (ROE) is expected to be 10%.
(4) The stock has a beta of 1.6%. The T-bond rate is 6%, and RP_M is estimated to be 5%.
(5) TII’s financial vice president recently polled some pension fund investment managers who hold TII’s securities regarding what minimum rate of return on TII’s common would make them willing to buy the common rather than TII bonds, given that the bonds yielded 11.8%. The responses suggested a risk premium over TII bonds of 3 percentage points.
(6) TII is in the 25% federal-plus-state tax bracket.

Assume that you were recently hired by TII as a financial analyst and that your boss, the treasurer, has asked you to estimate the company’s WACC under the assumption that no new equity will be issued. Your cost of capital should be appropriate for use in evaluating projects that are in the same risk class as the assets TII now operates. Based on your analysis, answer the following questions.

a. What are the current market value weights for debt, preferred stock, and common stock? (Hint: Do your work in dollars, not millions of dollars. When you calculate the market values of debt and preferred stock, be sure to round the market price per bond and the market price per share of preferred to the nearest penny.)
b. What is the after-tax cost of debt?
c. What is the cost of preferred stock?
d. What is the required return on common stock using CAPM?
e. Use the retention growth equation to estimate the expected growth rate. Then use the expected growth rate and the dividend growth model to estimate the required return on common stock.
f. What is the required return on common stock using the own-bond-yield-plus-judgmental-risk-premium approach?
g. Use the required return on stock from the CAPM model, and calculate the WACC.

a.

Expert Solution

Summary Introduction

To determine: The market value weights of debt, common stock and preferred stock.

Answer to Problem 17P

The market value weights of debt are 20%, common stock is 76% and preferred stock is 4%.

Explanation of Solution

Determine the market value weights of debt, common stock and preferred stock

Excel Spreadsheet:

Financial Management: Theory & Practice, Chapter 9, Problem 17P , additional homework tip 1

Excel Workings:

Financial Management: Theory & Practice, Chapter 9, Problem 17P , additional homework tip 2

Therefore, the market value weights of debt are 20%, common stock is 76% and preferred stock is 4%.

b.

Expert Solution

Summary Introduction

To determine: The after-tax cost of debt.

Answer to Problem 17P

The after-tax cost of debt is 8.85%.

Explanation of Solution

Determine the after-tax cost of debt

Aftertax Cost of Debt=[Pretax Cost of Debt×(1−Tax Rate)]=[11.80%×(1−25%)]=0.0885 or 8.85%

Therefore, the after-tax cost of debt is 8.85%.

c.

Expert Solution

Summary Introduction

To determine: The cost of preferred stock.

Answer to Problem 17P

The cost of preferred stock is 10.40%.

Explanation of Solution

Determine the cost of preferred stock

Cost of Preferred Stock=[Annual Preferred DividendStock Price×(1−Flotation Costs)]=[$100×10%$100×(1−3.85%)]=[$10$96.15]=0.104004 or 10.40%

Therefore, the cost of preferred stock is 10.40%.

d.

Expert Solution

Summary Introduction

To determine: The required return on common stock using CAPM.

Answer to Problem 17P

The required return on common stock using CAPM is 14%.

Explanation of Solution

Determine the required return on common stock using CAPM

Cost of Common StockCAPM=[Riskfree Rate+Beta×Market Risk Premium]=[6%+1.6×5%]=14%

Therefore, the required return on common stock using CAPM is 14%.

e.

Expert Solution

Summary Introduction

To determine: The required return on common stock using dividend growth model.

Answer to Problem 17P

The required return on common stock using dividend growth model is 13.40%.

Explanation of Solution

Determine the payout ratio

Payout Ratio=[Dividend per shareEarnings per share]=[$1$5]=20%

Therefore, the payout ratio is 20%.

Determine the growth rate

Growth Rate=[ROE×(1−Payout Ratio)]=[10%×(1−20%)]=8%

Therefore, the growth rate is 8%.

Determine the required return on common stock using dividend growth model

Cost of Common StockDividend Growth=[(Dividends×(1+Growth Rate)Stock Price)+Growth Rate]=[($1×(1+8%)$20)+8%]=[0.054+0.08]=13.40%

Therefore, the required return on common stock using dividend growth model is 13.40%.

f.

Expert Solution

Summary Introduction

To determine: The required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach.

Answer to Problem 17P

The required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach is 14.80%.

Explanation of Solution

Determine the required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach

Cost of Common StockBond Yield Judgemental=[Bond Yield+Risk Premium Percentage Points]=[11.8%+3%]=14.80%

Therefore, the required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach is 14.80%.

g.

Expert Solution

Summary Introduction

To determine: The WACC.

Answer to Problem 17P

The WACC is 12.83%.

Explanation of Solution

Determine the WACC

WACC=[((WeightDebt×RateDebt)×(1−Tax))+(WeightPreferred Stock×RatePreferred Stock)+(WeightCommon Stock×RateCommon Stock)]=[((20%×8.85%))+(4%×10.40%)+(76%×14%)]=[1.77%+0.42%+10.64%]=12.83%

Therefore, the WACC is 12.83%.

Want to see more full solutions like this?

Subscribe now to access step-by-step solutions to millions of textbook problems written by subject matter experts!

Answer 4

Textbook Question

Chapter 9, Problem 17P

The following table gives the current balance sheet for Travellers Inn Inc. (TII), a company that was formed by merging a number of regional motel chains.

Travellers Inn (Millions of Dollars)

Chapter 9, Problem 17P, The following table gives the current balance sheet for Travellers Inn Inc. (TII), a company that

The following facts also apply to TII.

(1) The long-term debt consists of 29,412 bonds, each having a 20-year maturity, semiannual payments, a coupon rate of 7.6%, and a face value of $1,000. Currently, these bonds provide investors with a yield to maturity of 11.8%. If new bonds were sold, they would have an 11.8% yield to maturity.
(2) TII’s perpetual preferred stock has a $100 par value, pays a quarterly dividend per share of $2, and has a yield to investors of 10%. New perpetual preferred stock would have to provide the same yield to investors, and the company would incur a 3.85% flotation cost to sell it.
(3) The company has 3.8 million shares of common stock outstanding, a price per share = P₀ = $20, dividend per share = D₀ = $1, and earnings per share = EPS₀ = $5. The return on equity (ROE) is expected to be 10%.
(4) The stock has a beta of 1.6%. The T-bond rate is 6%, and RP_M is estimated to be 5%.
(5) TII’s financial vice president recently polled some pension fund investment managers who hold TII’s securities regarding what minimum rate of return on TII’s common would make them willing to buy the common rather than TII bonds, given that the bonds yielded 11.8%. The responses suggested a risk premium over TII bonds of 3 percentage points.
(6) TII is in the 25% federal-plus-state tax bracket.

Assume that you were recently hired by TII as a financial analyst and that your boss, the treasurer, has asked you to estimate the company’s WACC under the assumption that no new equity will be issued. Your cost of capital should be appropriate for use in evaluating projects that are in the same risk class as the assets TII now operates. Based on your analysis, answer the following questions.

a. What are the current market value weights for debt, preferred stock, and common stock? (Hint: Do your work in dollars, not millions of dollars. When you calculate the market values of debt and preferred stock, be sure to round the market price per bond and the market price per share of preferred to the nearest penny.)
b. What is the after-tax cost of debt?
c. What is the cost of preferred stock?
d. What is the required return on common stock using CAPM?
e. Use the retention growth equation to estimate the expected growth rate. Then use the expected growth rate and the dividend growth model to estimate the required return on common stock.
f. What is the required return on common stock using the own-bond-yield-plus-judgmental-risk-premium approach?
g. Use the required return on stock from the CAPM model, and calculate the WACC.

a.

Expert Solution

Summary Introduction

To determine: The market value weights of debt, common stock and preferred stock.

Answer to Problem 17P

The market value weights of debt are 20%, common stock is 76% and preferred stock is 4%.

Explanation of Solution

Determine the market value weights of debt, common stock and preferred stock

Excel Spreadsheet:

Financial Management: Theory & Practice, Chapter 9, Problem 17P , additional homework tip 1

Excel Workings:

Financial Management: Theory & Practice, Chapter 9, Problem 17P , additional homework tip 2

Therefore, the market value weights of debt are 20%, common stock is 76% and preferred stock is 4%.

b.

Expert Solution

Summary Introduction

To determine: The after-tax cost of debt.

Answer to Problem 17P

The after-tax cost of debt is 8.85%.

Explanation of Solution

Determine the after-tax cost of debt

Aftertax Cost of Debt=[Pretax Cost of Debt×(1−Tax Rate)]=[11.80%×(1−25%)]=0.0885 or 8.85%

Therefore, the after-tax cost of debt is 8.85%.

c.

Expert Solution

Summary Introduction

To determine: The cost of preferred stock.

Answer to Problem 17P

The cost of preferred stock is 10.40%.

Explanation of Solution

Determine the cost of preferred stock

Cost of Preferred Stock=[Annual Preferred DividendStock Price×(1−Flotation Costs)]=[$100×10%$100×(1−3.85%)]=[$10$96.15]=0.104004 or 10.40%

Therefore, the cost of preferred stock is 10.40%.

d.

Expert Solution

Summary Introduction

To determine: The required return on common stock using CAPM.

Answer to Problem 17P

The required return on common stock using CAPM is 14%.

Explanation of Solution

Determine the required return on common stock using CAPM

Cost of Common StockCAPM=[Riskfree Rate+Beta×Market Risk Premium]=[6%+1.6×5%]=14%

Therefore, the required return on common stock using CAPM is 14%.

e.

Expert Solution

Summary Introduction

To determine: The required return on common stock using dividend growth model.

Answer to Problem 17P

The required return on common stock using dividend growth model is 13.40%.

Explanation of Solution

Determine the payout ratio

Payout Ratio=[Dividend per shareEarnings per share]=[$1$5]=20%

Therefore, the payout ratio is 20%.

Determine the growth rate

Growth Rate=[ROE×(1−Payout Ratio)]=[10%×(1−20%)]=8%

Therefore, the growth rate is 8%.

Determine the required return on common stock using dividend growth model

Cost of Common StockDividend Growth=[(Dividends×(1+Growth Rate)Stock Price)+Growth Rate]=[($1×(1+8%)$20)+8%]=[0.054+0.08]=13.40%

Therefore, the required return on common stock using dividend growth model is 13.40%.

f.

Expert Solution

Summary Introduction

To determine: The required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach.

Answer to Problem 17P

The required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach is 14.80%.

Explanation of Solution

Determine the required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach

Cost of Common StockBond Yield Judgemental=[Bond Yield+Risk Premium Percentage Points]=[11.8%+3%]=14.80%

Therefore, the required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach is 14.80%.

g.

Expert Solution

Summary Introduction

To determine: The WACC.

Answer to Problem 17P

The WACC is 12.83%.

Explanation of Solution

Determine the WACC

WACC=[((WeightDebt×RateDebt)×(1−Tax))+(WeightPreferred Stock×RatePreferred Stock)+(WeightCommon Stock×RateCommon Stock)]=[((20%×8.85%))+(4%×10.40%)+(76%×14%)]=[1.77%+0.42%+10.64%]=12.83%

Therefore, the WACC is 12.83%.

Want to see more full solutions like this?

Subscribe now to access step-by-step solutions to millions of textbook problems written by subject matter experts!

Answer 5

Textbook Question

Answer 6

Textbook Question

Answer 7

a.

Expert Solution

Summary Introduction

To determine: The market value weights of debt, common stock and preferred stock.

Answer to Problem 17P

The market value weights of debt are 20%, common stock is 76% and preferred stock is 4%.

Explanation of Solution

Determine the market value weights of debt, common stock and preferred stock

Excel Spreadsheet:

Financial Management: Theory & Practice, Chapter 9, Problem 17P , additional homework tip 1

Excel Workings:

Financial Management: Theory & Practice, Chapter 9, Problem 17P , additional homework tip 2

Therefore, the market value weights of debt are 20%, common stock is 76% and preferred stock is 4%.

b.

Expert Solution

Summary Introduction

To determine: The after-tax cost of debt.

Answer to Problem 17P

The after-tax cost of debt is 8.85%.

Explanation of Solution

Determine the after-tax cost of debt

Aftertax Cost of Debt=[Pretax Cost of Debt×(1−Tax Rate)]=[11.80%×(1−25%)]=0.0885 or 8.85%

Therefore, the after-tax cost of debt is 8.85%.

c.

Expert Solution

Summary Introduction

To determine: The cost of preferred stock.

Answer to Problem 17P

The cost of preferred stock is 10.40%.

Explanation of Solution

Determine the cost of preferred stock

Cost of Preferred Stock=[Annual Preferred DividendStock Price×(1−Flotation Costs)]=[$100×10%$100×(1−3.85%)]=[$10$96.15]=0.104004 or 10.40%

Therefore, the cost of preferred stock is 10.40%.

d.

Expert Solution

Summary Introduction

To determine: The required return on common stock using CAPM.

Answer to Problem 17P

The required return on common stock using CAPM is 14%.

Explanation of Solution

Determine the required return on common stock using CAPM

Cost of Common StockCAPM=[Riskfree Rate+Beta×Market Risk Premium]=[6%+1.6×5%]=14%

Therefore, the required return on common stock using CAPM is 14%.

e.

Expert Solution

Summary Introduction

To determine: The required return on common stock using dividend growth model.

Answer to Problem 17P

The required return on common stock using dividend growth model is 13.40%.

Explanation of Solution

Determine the payout ratio

Payout Ratio=[Dividend per shareEarnings per share]=[$1$5]=20%

Therefore, the payout ratio is 20%.

Determine the growth rate

Growth Rate=[ROE×(1−Payout Ratio)]=[10%×(1−20%)]=8%

Therefore, the growth rate is 8%.

Determine the required return on common stock using dividend growth model

Cost of Common StockDividend Growth=[(Dividends×(1+Growth Rate)Stock Price)+Growth Rate]=[($1×(1+8%)$20)+8%]=[0.054+0.08]=13.40%

Therefore, the required return on common stock using dividend growth model is 13.40%.

f.

Expert Solution

Summary Introduction

To determine: The required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach.

Answer to Problem 17P

The required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach is 14.80%.

Explanation of Solution

Determine the required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach

Cost of Common StockBond Yield Judgemental=[Bond Yield+Risk Premium Percentage Points]=[11.8%+3%]=14.80%

Therefore, the required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach is 14.80%.

g.

Expert Solution

Summary Introduction

To determine: The WACC.

Answer to Problem 17P

The WACC is 12.83%.

Explanation of Solution

Determine the WACC

WACC=[((WeightDebt×RateDebt)×(1−Tax))+(WeightPreferred Stock×RatePreferred Stock)+(WeightCommon Stock×RateCommon Stock)]=[((20%×8.85%))+(4%×10.40%)+(76%×14%)]=[1.77%+0.42%+10.64%]=12.83%

Therefore, the WACC is 12.83%.

Answer 8

a.

Expert Solution

Summary Introduction

To determine: The market value weights of debt, common stock and preferred stock.

Answer to Problem 17P

The market value weights of debt are 20%, common stock is 76% and preferred stock is 4%.

Explanation of Solution

Determine the market value weights of debt, common stock and preferred stock

Excel Spreadsheet:

Financial Management: Theory & Practice, Chapter 9, Problem 17P , additional homework tip 1

Excel Workings:

Financial Management: Theory & Practice, Chapter 9, Problem 17P , additional homework tip 2

Therefore, the market value weights of debt are 20%, common stock is 76% and preferred stock is 4%.

Answer 9

a.

Expert Solution

Answer 10

a.

Expert Solution

Answer 11

Expert Solution

Answer 12

Summary Introduction

To determine: The market value weights of debt, common stock and preferred stock.

Answer 13

Answer to Problem 17P

The market value weights of debt are 20%, common stock is 76% and preferred stock is 4%.

Answer 14

Explanation of Solution

Determine the market value weights of debt, common stock and preferred stock

Excel Spreadsheet:

Financial Management: Theory & Practice, Chapter 9, Problem 17P , additional homework tip 1

Excel Workings:

Financial Management: Theory & Practice, Chapter 9, Problem 17P , additional homework tip 2

Therefore, the market value weights of debt are 20%, common stock is 76% and preferred stock is 4%.

Answer 15

b.

Expert Solution

Summary Introduction

To determine: The after-tax cost of debt.

Answer to Problem 17P

The after-tax cost of debt is 8.85%.

Explanation of Solution

Determine the after-tax cost of debt

Aftertax Cost of Debt=[Pretax Cost of Debt×(1−Tax Rate)]=[11.80%×(1−25%)]=0.0885 or 8.85%

Therefore, the after-tax cost of debt is 8.85%.

Answer 16

b.

Expert Solution

Answer 17

b.

Expert Solution

Answer 18

Expert Solution

Answer 19

Summary Introduction

To determine: The after-tax cost of debt.

Answer 20

Answer to Problem 17P

The after-tax cost of debt is 8.85%.

Answer 21

Explanation of Solution

Determine the after-tax cost of debt

Aftertax Cost of Debt=[Pretax Cost of Debt×(1−Tax Rate)]=[11.80%×(1−25%)]=0.0885 or 8.85%

Therefore, the after-tax cost of debt is 8.85%.

Answer 22

c.

Expert Solution

Summary Introduction

To determine: The cost of preferred stock.

Answer to Problem 17P

The cost of preferred stock is 10.40%.

Explanation of Solution

Determine the cost of preferred stock

Cost of Preferred Stock=[Annual Preferred DividendStock Price×(1−Flotation Costs)]=[$100×10%$100×(1−3.85%)]=[$10$96.15]=0.104004 or 10.40%

Therefore, the cost of preferred stock is 10.40%.

Answer 23

c.

Expert Solution

Answer 24

c.

Expert Solution

Answer 25

Expert Solution

Answer 26

Summary Introduction

To determine: The cost of preferred stock.

Answer 27

Answer to Problem 17P

The cost of preferred stock is 10.40%.

Answer 28

Explanation of Solution

Determine the cost of preferred stock

Cost of Preferred Stock=[Annual Preferred DividendStock Price×(1−Flotation Costs)]=[$100×10%$100×(1−3.85%)]=[$10$96.15]=0.104004 or 10.40%

Therefore, the cost of preferred stock is 10.40%.

Answer 29

d.

Expert Solution

Summary Introduction

To determine: The required return on common stock using CAPM.

Answer to Problem 17P

The required return on common stock using CAPM is 14%.

Explanation of Solution

Determine the required return on common stock using CAPM

Cost of Common StockCAPM=[Riskfree Rate+Beta×Market Risk Premium]=[6%+1.6×5%]=14%

Therefore, the required return on common stock using CAPM is 14%.

Answer 30

d.

Expert Solution

Answer 31

d.

Expert Solution

Answer 32

Expert Solution

Answer 33

Summary Introduction

To determine: The required return on common stock using CAPM.

Answer 34

Answer to Problem 17P

The required return on common stock using CAPM is 14%.

Answer 35

Explanation of Solution

Determine the required return on common stock using CAPM

Cost of Common StockCAPM=[Riskfree Rate+Beta×Market Risk Premium]=[6%+1.6×5%]=14%

Therefore, the required return on common stock using CAPM is 14%.

Answer 36

e.

Expert Solution

Summary Introduction

To determine: The required return on common stock using dividend growth model.

Answer to Problem 17P

The required return on common stock using dividend growth model is 13.40%.

Explanation of Solution

Determine the payout ratio

Payout Ratio=[Dividend per shareEarnings per share]=[$1$5]=20%

Therefore, the payout ratio is 20%.

Determine the growth rate

Growth Rate=[ROE×(1−Payout Ratio)]=[10%×(1−20%)]=8%

Therefore, the growth rate is 8%.

Determine the required return on common stock using dividend growth model

Cost of Common StockDividend Growth=[(Dividends×(1+Growth Rate)Stock Price)+Growth Rate]=[($1×(1+8%)$20)+8%]=[0.054+0.08]=13.40%

Therefore, the required return on common stock using dividend growth model is 13.40%.

Answer 37

e.

Expert Solution

Answer 38

e.

Expert Solution

Answer 39

Expert Solution

Answer 40

Summary Introduction

To determine: The required return on common stock using dividend growth model.

Answer 41

Answer to Problem 17P

The required return on common stock using dividend growth model is 13.40%.

Answer 42

Explanation of Solution

Determine the payout ratio

Payout Ratio=[Dividend per shareEarnings per share]=[$1$5]=20%

Therefore, the payout ratio is 20%.

Determine the growth rate

Growth Rate=[ROE×(1−Payout Ratio)]=[10%×(1−20%)]=8%

Therefore, the growth rate is 8%.

Determine the required return on common stock using dividend growth model

Cost of Common StockDividend Growth=[(Dividends×(1+Growth Rate)Stock Price)+Growth Rate]=[($1×(1+8%)$20)+8%]=[0.054+0.08]=13.40%

Therefore, the required return on common stock using dividend growth model is 13.40%.

Answer 43

f.

Expert Solution

Summary Introduction

To determine: The required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach.

Answer to Problem 17P

The required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach is 14.80%.

Explanation of Solution

Determine the required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach

Cost of Common StockBond Yield Judgemental=[Bond Yield+Risk Premium Percentage Points]=[11.8%+3%]=14.80%

Therefore, the required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach is 14.80%.

Answer 44

f.

Expert Solution

Answer 45

f.

Expert Solution

Answer 46

Expert Solution

Answer 47

Summary Introduction

To determine: The required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach.

Answer 48

Answer to Problem 17P

The required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach is 14.80%.

Answer 49

Explanation of Solution

Determine the required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach

Cost of Common StockBond Yield Judgemental=[Bond Yield+Risk Premium Percentage Points]=[11.8%+3%]=14.80%

Therefore, the required return on common stock using own-bond-yield-plus-judgmental- risk-premium approach is 14.80%.

Answer 50

g.

Expert Solution

Summary Introduction

To determine: The WACC.

Answer to Problem 17P

The WACC is 12.83%.

Explanation of Solution

Determine the WACC

WACC=[((WeightDebt×RateDebt)×(1−Tax))+(WeightPreferred Stock×RatePreferred Stock)+(WeightCommon Stock×RateCommon Stock)]=[((20%×8.85%))+(4%×10.40%)+(76%×14%)]=[1.77%+0.42%+10.64%]=12.83%

Therefore, the WACC is 12.83%.

Answer 51

g.

Expert Solution

Answer 52

g.

Expert Solution

Answer 53

Expert Solution

Answer 54

Summary Introduction

To determine: The WACC.

Answer 55

Answer to Problem 17P

The WACC is 12.83%.

Answer 56

Explanation of Solution

Determine the WACC

WACC=[((WeightDebt×RateDebt)×(1−Tax))+(WeightPreferred Stock×RatePreferred Stock)+(WeightCommon Stock×RateCommon Stock)]=[((20%×8.85%))+(4%×10.40%)+(76%×14%)]=[1.77%+0.42%+10.64%]=12.83%