Question

Austrian MotorWorks (AMW) has the following capital structure:

1)700,000 shares of common stock, which were issued at a price of $20 per share, and currently trade on the capital markets at $42 per share. The company paid a dividend this year of $1.00, and has a beta of 1.20
2)50.000 shares of 5.5% preferred stock, which were issued at par of $75 and currently trade on the capital markets at $77 per share.
3)20,0004% semi-annual bonds with a par value of $1,000 each. The bonds have 17 years to maturity and currently sell for 98% of par. Tudor's marginal tax rate is 30%. The return from the market 9.0%; and the risk-free rate is 2.0%
a. What is the firm's capital structure based on market values?
b. What is Tudor's (after-tax) cost of common stock?
c. What is Tudor's (after-tax) cost of preferred stock?
d. What is Tudor's (after-tax) cost of debt?
e. Calculate Tudor's weighted average cost of capital.

Answer 1

a. The firm's capital structure based on market values is $52,850,000. b. The after-tax cost of common stock is 2.38%. c. The after-tax cost of preferred stock is 0.338%. d. The after-tax cost of debt is 2.8%. e. Tudor's weighted average cost of capital is 2.21%.

Step-by-step explanation:

a. To determine the firm's capital structure based on market values, we need to calculate the market value of each component of the capital structure. The market value of common stock can be calculated by multiplying the number of shares by the current market price per share: 700,000 shares * $42 = $29,400,000. The market value of preferred stock can be calculated similarly: 50,000 shares * $77 = $3,850,000. The market value of bonds can be calculated by multiplying the number of bonds by the current market price per bond: 20,000 bonds * $1,000 * 0.98 = $19,600,000. Therefore, the firm's capital structure based on market values is $29,400,000 + $3,850,000 + $19,600,000 = $52,850,000.

b. The after-tax cost of common stock can be calculated using the dividend discount model. The cost of common stock is the dividend per share divided by the current market price per share, multiplied by (1 - tax rate). In this case, the dividend per share is $1.00 and the current market price per share is $42. The after-tax cost of common stock is ($1.00 / $42) * (1 - 0.30) = 0.0238 or 2.38%.

c. The after-tax cost of preferred stock can be calculated using the formula: preferred stock dividend rate divided by the current market price per share, multiplied by (1 - tax rate). In this case, the preferred stock dividend rate is 5.5% and the current market price per share is $77. The after-tax cost of preferred stock is (0.055 / $77) * (1 - 0.30) = 0.00338 or 0.338%.

d. The after-tax cost of debt can be calculated using the formula: yield to maturity of the bonds multiplied by (1 - tax rate). In this case, the yield to maturity is 4% (semi-annual) and the tax rate is 30%. The after-tax cost of debt is 0.04 * (1 - 0.30) = 0.028 or 2.8%.

e. The weighted average cost of capital (WACC) can be calculated by taking the weighted average of the after-tax costs of each component, weighted by their respective market values. In this case, the market values are $29,400,000 for common stock, $3,850,000 for preferred stock, and $19,600,000 for bonds. The WACC is therefore ((0.0238 * $29,400,000) + (0.00338 * $3,850,000) + (0.028 * $19,600,000)) / $52,850,000 = 0.0221 or 2.21%.