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Kuwait University College of Business Administration Department of Finance & Financial Institutions Capital Budgeting and Long-term Financing 2nd Mid-term’s Exam Spring 2005-2006 Model Answer 2nd Mid-term Exam SOA Inc., current capital structure consists of $10,000,000 in long-term loan, 20,000 bonds, 100,000 preferred stocks, $30,000,000 in common stocks, and $10,000,000 in retained earnings. 1. The bank charges SOA Inc. a risk premium of 3% above the risk free rate. The real interest rate (R*) in the economy is 4% and inflation is expected to be 5% over the next few years (Rf = R* + Inf.). 2. The SOA Inc.'s 10-years bonds are issued at 12% semiannual coupon, have a current time to maturity of 4 years, sells for $923, and interest rate on comparable bonds is 14%. 3. The Inc.'s preferred stocks have face value of $100, pay 11% annual dividends, and have a market value of $92 per share. 4. SOA Inc. is constant growth firm which just paid dividends of $2.00, has a growth rate of 4%, and its common stocks are traded for $25.00 per share. 5. SOA Inc. is subject to 40% corporate tax. Given that: SOA Inc. has a new project for $20,000,000 that can be financed through bank's loans or common stocks. A. If the project financed through the bank loans, the bank will charge the SOA Inc. the same interest rate charge for the old loan, but the interest will be paid at the beginning of the year. B. The bank's loan will increase the company risk, therefore the common shareholders are expected to ask for 1% increase in the required rate of return (cost of common stocks will increase by 1%). C. If the project financed through issuing common stocks, nothing will change in the company's cost structure. D. SOA Inc. has 40% probability to finance the new project through bank loan and 60% probability to finance the project through issuing common stocks. Kindly: 1. Calculate the WACC under each scenario. 2. Calculate the Expected WACC. 3. Calculate the Standard Deviation of the WACC. GOOOOOOOOOOOOD LUCK 1 2nd Mid-term Exam Model Answer Capital Structure Bank Loans Old New 10,000,000 20,000,000 10% 20% 7.20% 0.7200% 10,000,000 8.18% 1.6360% 10% 7.20% 0.7200% Bonds 20,000,000 20% 9.08% 1.8160% 20,000,000 20% 9.08% 1.8160% Preferred Stocks 10,000,000 10% 11.96% 1.1960% 10,000,000 10% 11.96% 1.1960% Common Stocks Old New 30,000,000 30% 13.32% 3.9960% 30,000,000 20,000,000 30% 20% 12.32% 3.6960% 12.32% 2.4640% Retained Earnings Total Cap 10,000,000 10% 12.32% 1.2320% 10,000,000 10% 12.32% 1.2320% 100,000,000 100% 10.596% 100,000,000 100% 11.124% $ Cap Scenario # 1 Weight Cost WACC $ Cap Scenario # 2 Weight Cost WACC Notice: 1. Cost of Old Loan = 4%+5%+3%= 12% * (1-40%) = 7.2% 2. Cost of New Loan = 12% (1 40%) 8.1818% 8.18% 1 12% 3. Cost of Bonds = YTM * (1-40%) = 15.13% * 60% = 9.08% Given That PV = -$923, PMT=Coupon = 1,000 * (12%/2) = $60, N = 4 * 2 = 8, FV = $1,000 Then YTM = 7.3% Semiannual = Annual YTM = (1+ 7.3%)2 – 1 = 15.13% 4. Cost of Preferred Stocks = 11 11.96% 92 5. Cost of Common Stocks = Cost of Retained Earnings = 2 * (1 4%) 4% 12.32% 25 Cost of Common Stocks Under First Scenario = 12.32%+1% 13.32% Expected WACC = (10.596% * 40%) + (11.124 * 60%) = 10.9128% ≈ 10.91% W ACC (10.91%10.596%) * 40% (10.91%11.124%)* * 60% 0.26% 2 2 2