Question

Western Electric has 35,000 ordinary shares outstanding at a price per share of $47 and a rate of return of 13.5%. The firm has 5,000 preference shares paying 7% dividend outstanding at a price of $58 a share. The preferred share has a par value of $100. The outstanding bond has a total face value of $450,000 and currently sells for 102% of face. The pre-tax yield-to-maturity on the bond is 8.49%. Required: a) Calculate the total market value of the firm. b) Calculate the capital structure of the firm. c) Calculate the firm's weighted average cost of capital if the tax rate is 30%, assuming a classical tax system.

Answer 1

a) Total market value of the firm = $2,394,000

b) The capital structure of the firm:

Weight of ordinary shares = 69%

Weight of preference shares = 12%

Weight of bond = 19%

c) The firm's weighted average cost of capital (WACC) = 11.28%

Step-by-step explanation:

a) Calculate the total market value of the firm.

Total market value of the firm is the addition market values of ordinary shares, preference shares and bond. This can be calculated as follows:

Market value of ordinary shares = $47 * 35,000 = $1,645,000

Market value of preference shares = $58 * 5,000 = $290,000

Market value of bond = $450,000 * 102% = $459,000

Therefore, we have:

Total market value of the firm = $1,645,000 + $290,000 + $459,000 = $2,394,000

b) Calculate the capital structure of the firm

Capital structure of the firm is the weight of the market value of each of capital or finance sources in the total market value. This can be calculated as follows:

Wo = Weight of ordinary shares = $1,645,000 / $2,394,000 = 0.69, or 69%

Wp = Weight of preference shares = $290,000 / $2,394,000 = 0.12, or 12%

Wb = Weight of bond = $459,000 / $2,394,000 = 0.19, or 19%

c) Calculate the firm's weighted average cost of capital if the tax rate is 30%, assuming a classical tax system.

The weighted average cost of capital (WACC) which is also referred to as firm's cost of capital refers to the rate the firm is expected to pay on average to all holders of its security used in financing its assets. The WACC can be estimated as follows:

WACC = (Ro * Wo) + (Rp * Wp) + (Yb * Wb * (1 - T)) .................... (1)

Whrere,

Ro = Rate of return of ordinary shares = 13.5%

Rp = Rate of return on preference shares = 7%

Yb = Pre-tax yield-to-maturity on the bond = 8.49%

T = Tax rate = 30%

Substituting the values above and the relevant values from part (b) above into equation (1), we have:

WAAC = (13.5% * 69%) + (7% * 12%) + (8.49% * 19% * (1 - 30%)) = 11.28%