Great Corporation's Capital And Debt Situation

Great Corporation Has The Following Capital Situationdebt One Thousa

Great Corporation has the following capital situation. Debt: One thousand bonds were issued five years ago at a coupon rate of 11%. They had 20-year terms and $1,000 face values. They are now selling to yield 9%. The tax rate is 37%. Preferred stock: Two thousand shares of preferred are outstanding, each of which pays an annual dividend of $7.50. They originally sold to yield 15% of their $50 face value. They're now selling to yield 11%. Equity: Great Corp has 108,000 shares of common stock outstanding, currently selling at $18.48 per share. Use the risk premium approach and assume a 3% risk premium.

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Introduction

Understanding a company's capital structure involves analyzing its debt, preferred stock, and equity components to determine the overall cost of capital. This comprehensive analysis aids in making informed financial decisions, including valuation, investment appraisal, and strategic planning. In this paper, we examine the specific financial components of Great Corporation, calculate its weighted average cost of capital (WACC), and interpret the implications of these calculations in the context of corporate finance.

Debt Analysis

Great Corporation issued bonds five years ago with a face value of $1,000 each, at an 11% coupon rate, with a maturity period of 20 years. Since issuance, five years have elapsed, and the bonds now sell at a yield of 9%. To compute the company's cost of debt after tax, we need to determine the yield to maturity (YTM) on the existing bonds, which reflects the market’s required return.

The bonds remain with a 15-year maturity (original 20-year term minus 5 years elapsed). The current market price of the bonds can be derived from the yield, but for simplicity, we can directly approximate the after-tax cost of debt using the current yield, adjusting for the tax shield. The pre-tax cost, or YTM, is approximately 9%.

The after-tax cost of debt (Kd) is calculated as:

\[ Kd = YTM \times (1 - T) \]

where \( T \) is the corporate tax rate (37%).

Thus,

\[ Kd = 9\% \times (1 - 0.37) = 9\% \times 0.63 = 5.67\% \]

This indicates that after accounting for tax advantages, the effective cost of debt for Great Corporation is approximately 5.67%.

Preferred Stock Analysis

Great Corporation has 2,000 preferred shares outstanding, each paying an annual dividend of $7.50. Initially, these preferred shares were issued at a 15% yield based on a $50 face value, but current market conditions have shifted, and the preferred stock now yields 11%.

The market price of preferred stock can be calculated from the dividend yield:

\[ \text{Market Price} = \frac{\text{Dividend}}{\text{Yield}} \]

Currently,

\[ \text{Market Price} = \frac{7.50}{0.11} \approx 68.18 \]

The total market value of preferred stock is:

\[ 2,000 \times 68.18 \approx 136,360 \]

The cost of preferred stock (Kp) is the dividend divided by the current market price:

\[ Kp = \frac{7.50}{68.18} \approx 11\% \]

This rate reflects the return required by investors for holding the preferred shares.

Equity (Common Stock) Analysis

Great Corporation has 108,000 common shares outstanding, trading at $18.48 per share. To determine the cost of equity (\( Ke \)), the risk premium approach is employed, assuming a risk-free rate plus a risk premium.

Suppose the current risk-free rate (Yields on Treasury bonds) is approximately 3% (as of recent data), and we are given a risk premium of 3%. The cost of equity is then calculated as:

\[ Ke = \text{Risk-free rate} + \text{Risk premium} = 3\% + 3\% = 6\% \]

However, in practice, investors require a higher return based on market conditions, but given the parameters, this simplified approach suffices for this analysis.

Alternatively, the dividend discount model (DDM) could provide an estimate, but since the prompt specifies the risk premium approach, we proceed with this method.

The market value of equity is:

\[ 108,000 \times 18.48 = 1,999,680 \]

The cost of equity is thus 6%, reflecting the return investors require given the company's risk profile.

Calculating the Weighted Average Cost of Capital (WACC)

The WACC formula incorporates the proportionate costs of debt, preferred stock, and equity:

\[

\text{WACC} = \left(\frac{D}{V} \times Kd\right) + \left(\frac{P}{V} \times Kp\right) + \left(\frac{E}{V} \times Ke\right)

\]

where:

- \( D \) = market value of debt,

- \( P \) = market value of preferred stock,

- \( E \) = market value of equity,

- \( V = D + P + E \),

- \( Kd \) = after-tax cost of debt,

- \( Kp \) = cost of preferred stock,

- \( Ke \) = cost of equity.

Calculating the total value:

\[

D = 1,000 \times 1,000 = 1,000,000 \\

P = 136,360 \\

E = 1,999,680 \\

V = 1,000,000 + 136,360 + 1,999,680 = 3,136,040

\]

Calculating weights:

\[

\frac{D}{V} = \frac{1,000,000}{3,136,040} \approx 0.319 \\

\frac{P}{V} = \frac{136,360}{3,136,040} \approx 0.043 \\

\frac{E}{V} = \frac{1,999,680}{3,136,040} \approx 0.638

\]

Finally, WACC calculation:

\[

\text{WACC} = (0.319 \times 5.67\%) + (0.043 \times 11\%) + (0.638 \times 6\%) \\

= 0.0181 + 0.0047 + 0.0383 \\

= 0.0611 \text{ or } 6.11\%

\]

Therefore, the weighted average cost of capital for Great Corporation is approximately 6.11%. This measure reflects the average rate that the company must pay to finance its assets and is crucial for investment appraisals and valuation models.

Conclusion

In summary, the analysis of Great Corporation's capital components reveals a diversified funding structure with a relatively low WACC, primarily driven by its debt component. The after-tax cost of debt is approximately 5.67%, indicating favorable borrowing conditions. The preferred stock carries an 11% return, and the company's equity demands a 6% return based on risk premium assumptions. Together, these components synthesize into a WACC of about 6.11%, providing a benchmark for evaluating investment opportunities and strategic financial decisions. Understanding these costs enables the company to optimize its capital structure, minimize its weighted average cost of capital, and enhance shareholder value.

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