(9-17) WACC Estimation

The following table gives the current balance sheet for Traveler Inn Inc. (TII), a company that was formed by merging a number of regional motel chains.

Travelers inn (Millions of Dollars)

Cash

$10

Account Payable

$10

Account Receivable

20

Accruals

15

Inventories

20

short-Term debt

0

Current Assets

$50

Current liabilities

$25

Net fixed assets

50

Long-Term debt

30

Preferred stock (50,000 shares)

5

Common Equity

Common Stock (3,800,000 shares)

$10

Retained Earnings

30

Total equity

$40

Total assets

$100

Total liabilities and equity

$100

The following facts also apply to TII

1.

The long- term debt consists of 29,412 bonds, each having a 20-

year maturity, semi- annual payments, a coupon rate of 7.6%, and a face value

of $1,000. Currently, these bonds provide investors with a yield to maturity of

11.8%. if new bonds were sold, they would have an 11.8% yield to maturity.

2.

TLL's perpetual stock has a $100 per value, pays a quarterly

dividend per shares of $2, and has a yield to investors of 10%. New perpetual

preferred stock would have to provide the same yield to investors, and the

company would incur a 3.85% flotation cost to sell it.

3.The company has 3.8 million shares of common stock outstanding, a price per share = Po = $20, dividend per share = Do = $1, and earning per share = EPSo = $5. The return on equity (ROE) is expected to be 10%.

4.

The stock has a beta pf 1.6%. The T-bond rate is 6%, and RPm is

estimated to be 5%.

5.TII's financial vice president recently polled some pension fund investment managers who hold TLL's securities regarding that minimum rate of return on TII's common would make them willing to buy the common rather than TLL bonds, given that the bonds yielded 11.8%. the responses suggested a risk premium over TLL bonds of 3% point.

6.TII is in the 25% federal -plus state tax bracket.

Assume that you were recently

hired by TLL as a financial analyst and that your boss, the treasurer, has

asked you to estimate the company's WACC under the assumption that no new

equity will be issued. You cost of capital should be appropriate for use in

evaluating projects that are in the same risk class as the assets TI now

operate. Based on your analysis, answer the following questions.

a.What are the current market value weights for debt, preferred stock, and common stock? (Hint: Do your work in dollars, not in millions of dollars. When you calculate the market values of debt and preferred stock, be sure to round the market price per bond and the market price per share of preferred to the nearest penny)

b.What Is the after-tax cost of debt?

c.What is the cost of preferred stock?

d.What is the required return on common stock using CAPM?

e.Use the retention growth equation to estimate the expected growth rate, then use the expected growth rate and the dividend growth model to estimate the required return on common stock.

f.What is the required return on common stock using the own-bond-yield-plus judgement-risk-premium approach?

g.Use the required return on stock from the CAPM model and calculate the WACC.