Week 4 Tutorial Question and Solutions 13/08/18

Chapter 13

QP:

11. Finding the WACC

Given the following information for Huntington Power Co., find the WACC. Assume the
company’s tax rate is 35 percent. Debt: 10,000 5.6 percent coupon bonds outstanding, $1,000
par value, 25 years to maturity, selling for 97 percent of par; the bonds make semi-annual
payments. Common stock: 425,000 shares outstanding, selling for $61 per share; the beta is .95.
Market: 7 percent market risk premium and 3.8 percent risk-free rate

We will begin by finding the market value of each type of financing. We find:

B = 10,000($1,000)(.97) = $9,700,000
S = 425,000($61) = $25,925,000

And the total market value of the firm is:

V = $9,700,000 + 25,925,000
V = $35,625,000

Now, we can find the cost of equity using the CAPM. The cost of equity is:

RS = .038 + .95(.07)
RS = .1045, or 10.45%

The cost of debt is the YTM of the bonds, so:

P0 = $970 = $28(PVIFAR%,50) + $1,000(PVIFR%,50)

R = 2.915%
YTM = 2.915% × 2 = 5.83%

And the aftertax cost of debt is:

RB = (1 – .35)(.0583)
RB = .0379, or 3.79%

Now we have all of the components to calculate the WACC. The WACC is:

RWACC = .0379($9,700,000 / $35,625,000) + .1045($25,925,000 / $35,625,000)

RWACC = .0864, or 8.64%

Notice that we didn’t include the (1 – tC) term in the WACC equation. We used the aftertax cost
of debt in the equation, so the term is not needed here.
Week 4 Tutorial Question and Solutions 13/08/18

15. Calculating Flotation Costs

Southern Alliance Company needs to raise $55 million to start a new project and will raise the
money by selling new bonds. The company will generate no internal equity for the foreseeable
future. The company has a target capital structure of 65 percent common stock, 5 percent
preferred stock, and 30 percent debt. Flotation costs for issuing new common stock are 7
percent; for new preferred stock, 4 percent; and for new debt, 3 percent.

What is the true initial cost figure Southern should use when evaluating its project?

We first need to find the weighted average flotation cost. Doing so, we find:

fT = .65(.07) + .05(.04) + .30(.03)

fT = .057, or 5.7%

And the total cost of the equipment including flotation costs is:

Amount raised(1 – .057) = $55,000,000

Amount raised = $55,000,000 / (1 – .057)
Amount raised = $58,293,588
Week 4 Tutorial Question and Solutions 13/08/18

20. Firm Valuation

Schultz Industries is considering the purchase of Arras Manufacturing. Arras is currently a

supplier for Schultz, and the acquisition would allow Schultz to better control its material
supply. The current cash flow from assets for Arras is $6.8 million. The cash flows are expected
to grow at 8 percent for the next five years before levelling off to 4 percent for the indefinite
future. The cost of capital for Schultz and Arras is 12 percent and 10 percent, respectively.
Arras currently has 2.5 million shares of stock outstanding and $30 million in debt outstanding.

What is the maximum price per share Schultz should pay for Arras?

We are given the total cash flow for the current year. To value the company, we need to calculate
the cash flows until the growth rate levels off at a constant perpetual rate. So, the cash flows each
year will be:

Year 1: $6,800,000(1 + .08) = $7,344,000

Year 2: $7,344,000(1 + .08) = $7,931,520
Year 3: $7,931,520(1 + .08) = $8,566,042
Year 4: $8,566,042(1 + .08) = $9,251,325
Year 5: $9,251,325(1 + .08) = $9,991,431
Year 6: $9,991,431(1 + .04) = $10,391,088

We can calculate the terminal value in Year 5 since the cash flows begin a perpetual growth rate.
Since we are valuing Arras, we need to use the cost of capital for that company since this rate is based
on the risk of Arras. The cost of capital for Schultz is irrelevant in this case. So, the terminal value is:

TV5 = CF6 / (RWACC – g)

TV5 = $10,391,088 / (.10 – .04)
TV5 = $173,184,803

Now we can discount the cash flows for the first 5 years as well as the terminal value back to
today. Again, using the cost of capital for Arras, we find the value of the company today is:

V0 = $7,344,000 / 1.10 + $7,931,520 / 1.102 + $8,566,042 / 1.103 + $9,251,325 / 1.104

+ ($9,991,431 + 173,184,803) / 1.105
V0 = $139,723,941

The market value of the equity is the market value of the company minus the market value of the
debt, or:

S = $139,723,941 – 30,000,000
S = $109,723,941

To find the maximum offer price, we divide the market value of equity by the shares outstanding,

Share price = $109,723,941 / 2,500,000

Share price = $43.89
Week 4 Tutorial Question and Solutions 13/08/18

Chapter 14

QP4. Market Efficiency Implications

Explain why a characteristic of an efficient market is that investments in that market have zero
N PVs

On average, the only return that is earned is the required return—investors buy assets with
returns in excess of the required return (positive NPV), bidding up the price and thus causing the
return to fall to the required return (zero NPV); investors sell assets with returns less than the
required return (negative NPV), driving the price lower and thus causing the return to rise to the
required return (zero NPV).

CP 9. Efficient Market Hypothesis

Several celebrated investors and stock pickers frequently mentioned in the financial press have
recorded huge returns on their investments over the past two decades. Does the success of these
particular investors invalidate the EMH? Explain.

The EMH only says, within the bounds of increasingly strong assumptions about the information
processing of investors, that assets are fairly priced. An implication of this is that, on average, the
typical market participant cannot earn excessive profits from a particular trading strategy.
However, that does not mean that a few particular investors cannot outperform the market over a
particular investment horizon. Certain investors who do well for a period of time get a lot of
attention from the financial press, but the scores of investors who do not do well over the same
period of time generally get considerably less attention from the financial press.

CP 15. Efficient Market Hypothesis

Aerotech, an aerospace technology research firm, announced this morning that it has hired the
worlds most knowledgeable and prolific space researchers. Before today, Aerotech’s stock had
been selling for $100. Assume that no other information is received over the next week and the
stock market as a whole does not move.

a. What do you expect will happen to Aerotech’s stock?

b. Consider the following scenarios:

i. The stock price jumps to $118 on the day of the announcement. In subsequent days it floats up
to $123, and then falls back to $116.

ii. The stock price jumps to $116 and remains at that level.

iii. The stock price gradually climbs to $116 over the next week.

a. Aerotech’s stock price should rise immediately after the announcement of the positive news.

b. Only scenario (ii) indicates market efficiency. In that case, the price of the stock rises
immediately to the level that reflects the new information, eliminating all possibility of
abnormal returns. In the other two scenarios, there are periods of time during which an
investor could trade on the information and earn abnormal returns.