Chapter 9.

Problem 17

Travelers Inn Incorporated: Book Values, Market Values, and the Target Capital Structure (Millions of Dollar

Balance Sheets

Assets

Cash $10

Receivables $20
Inventories $20
Total Current Assets $50

Net fixed assets $50

Total assets $100

1. Short term debt consists of bank loans that currently cost 10% with interest payable quarterly. These loans are u
so bank loans are zero in the off-season.

2. The long term debt consists of 20 year semi-annual payment mortgage bonds with a coupon rate of 8%. Current
If new bond were sold, they would have a 12% yield to maturity.

3. The company's perpetual preferred stock has a $100 par value, pays a quarterly dividend of $2, and has a yield to
the same yield to investors and the company would incur a 5% flotation cost to sell it.

4. The company has 4 million shares of common stock outstanding, P0 = $20, but the stock has recently traded in th
on average equity was 24% in 2008, but management expects to increase this return on equity to 30%; however
optimism in this regard.

5. Betas as reported by security analysts, range from 1.3 to 1.7; the T-bond rate is 10%, and RPm is estimated by v
 brokerage house analysts report forecasted dividend growth rates in the range of 10% to 15% over the foreseeab

6. The company's vice president recently polled some pension fund managers who hold the company's securities re
need to be make them willing to buy the common rather than bonds, given that the bonds yielded 12%. The resp

7. The federal, plus state tax bracket is 40%.

8. The company's principal investment banker predicts a decline in interest rates, with rd falling to 10% and the T-bo
expected inflation rate could lead to an increase rather than a decrease in interest rates.

Estimate the company's WACC under the assumption that no new equity will be issued. Your cost of capital shou
as the assets the company now operates.

Number of years to maturity 20

Number of payments per year 2
Annual coupon rate 8%
Par value $1,000
Current price = PV = 1084.11
Current price = PV = ($1,084.11)
N= 40
PMT = $40
FV = $1,000

I/YR = rd = 3.60%

Annualized rd = 7.20%

Number of years to maturity 20

Number of payments per year 2
Annual coupon rate 12%
Face value $1,000
Tax rate 40%

N= 40
PV = ($608.84)
PMT = $60
FV = $1,000

I/YR = rd = 10.00%

Annualized rd = 20.00%
A-T rd = 12.00%
 Chapter 9. Problem 17

and the Target Capital Structure (Millions of Dollars, December 31, 2009)

Investor-Supplied Ca
Book
Percent Book
Liabilities and Equity of Total Value

Accounts payable $10 10%

Accruals $10 10%
Spontaneous liabilities $20 20%
Short term debt $5 $5
Total Current Liabilities $25 25%
Long-term debt $30 30% $30
Total liabilities $55 55% $35
Preferred stock $5 5% $5
Common stock $10 10% $10
Retained earnings $30 30% $30
Total common equity $40 40% $40
Total liabilities and equity $100 100% $80

0% with interest payable quarterly. These loans are used to finance receivables and inventories on a seasonal basis

nt mortgage bonds with a coupon rate of 8%. Currently, these bonds provide a yield to investors of rd = 12%.

alue, pays a quarterly dividend of $2, and has a yield to investors of 11%. New perpetual preferred would have to provide
5% flotation cost to sell it.

nding, P0 = $20, but the stock has recently traded in the price range from $17 to $23. D0 = $1 and EPS0 = $2. ROE based
ects to increase this return on equity to 30%; however, security analysts and investors generally are not aware of management

7; the T-bond rate is 10%, and RPm is estimated by various brokerage houses to be in the range from 4.5% to 5.5%. Some
h rates in the range of 10% to 15% over the foreseeable future.

n fund managers who hold the company's securities regarding what the minimum rate of return on the company's common stoc
an bonds, given that the bonds yielded 12%. The responses suggested a risk premium over the bonds of 4 to 6 percentage poi

ne in interest rates, with rd falling to 10% and the T-bond rate to 8%, although the bank acknowledges that an increase in the
n a decrease in interest rates.

no new equity will be issued. Your cost of capital should be appropriate for use in evaluating projects that are in the same risk c

Pref. Dividend $8.00

Par value $100.00
Flotation % 5.0%
Net preferred issue price $95.00

rps = 8.42%

wd (short) 0.00%
wd (long) 20.00%
 Investor-Supplied Capital
Book Market Target
Capital
Percent Market Percent Structure
of Total Value of Total

6.3% $5 4.17%

37.5% $30 25.00%

43.8% $35 29.17% wd =

6.3% $5 4.17% wps =

12.5%
37.5%
50.0% $80 66.67% ws =

100.0% $120 100.00%

ies on a seasonal basis

tors of rd = 12%.

ferred would have to provide

1 and EPS0 = $2. ROE based

ally are not aware of management's

ange from 4.5% to 5.5%. Some

n on the company's common stock would
he bonds of 4 to 6 percentage points.

owledges that an increase in the

projects that are in the same risk class

Beta 1.70
10-year T-bond yield 8.0%
Market risk premium 5.5%

rs = 17.35%

Risk-free rate 8.0%

Market risk premium 5.5%
Beta 1.7
rs = rRF + (RPM) (bi)
rs = 8.0% + 5.5% 1.7
rs = 8.0% + 9.4%
rs = 17.35%

Growth rate of dividend 10.0%

Stock price $100.00
Expected dividend $8.00

rs 18.00%

WACC = Weighted average cost of capital

= wd rd(1 – T) + wps rps + ws rs

rd = Cost of debt
rps = Cost of preferred stock
rs = Cost of stock (comon equity)

wd = Percent of target capital structure financed with debt

wps = Percent of target capital structure financed with preferred stock
ws = Percent of target capital structure financed with stock (common equity)

T = Tax rate
Required Answers:
wd (short)
wd (long)
wps
ws
rd
rps
rs
k (common equity)
COST OF DEBT, rd
The relevant cost of debt is the after-tax cost of new debt, taking account of the tax deductibility of interest. The after-t
rate (or the before-tax cost of debt) times one minus the tax rate.

The after-tax cost of debt-capital = The Yield-to-Maturity on long-term debt x (1 minus the marginal tax rate
rd = 12%(1-.40)
rd = 7.20%

COST OF PREFERRED STOCK, rp

The cost of preferred stock is simply the preferred dividend divided by the price the company will receive if it issues new
necessary, as preferred dividends are not tax deductible.

PROBLEM
New perpetual preferred has a yield to investors of 11%.
Annual dividend on new preferred = 11% ($100) = $11
Par value $100.00
Flotation % 5.0%

rps = Pref. Dividend ÷ Pref. Stock Price (1 - F)

$11 ÷ 100(1-0.05)
rps = 11.60%

rps = 11.6%

COST OF COMMON EQUITY , r(s)

cost of common equity by CAPM approach:

Formula:

r s = R RF b∗ RP M 

b = beta of systematic risk of the firm

RPM = Expected market risk premium
RR F = Risk Free Rate

In this Question , We have:

r(RF) = 10%= T-bond rate
RP(m) = ranges from 4.5 to 5.5 %
Beta = ranges from 1.3 to 1.7
so, we can get r(s) as
Highest r(s) = 10% + (5.5)(1.7) = 19.35%
Midpoint r(s) = 10% + (5.)(1.5) = 17.50%
Lowest r(s) = 10%+(4.5)(1.3) = 15.85%
of interest. The after-tax calculated by multiplying the interest

the marginal tax rate in %)

ll receive if it issues new preferred stock. No tax adjustment is

Number of Periods 40 40 40
RATE 12% 6% 1%
$8.24