Problem 9-17

WACC Estimation The table below gives the balance sheet for Travellers Inn Inc. (TII), a company that was formed by merging a number of regional motel chains.

Travellers Inn: December 31, 2012 (Millions of Dollars)

Cash $10 Accounts payable $10 Accounts receivable 20 Accruals 10 Inventories 20 Short-term debt 5 Current assets $50 Current liabilities $25 Net fixed assets 50 Long-term debt 30 Preferred stock 5 Common equity Common stock $10 Retained earnings 30 Total common equity $40 Total assets $100 Total liabilities and equity $100 The following facts also apply to TII:

Short-term debt consists of bank loans that currently cost 9%, with interest payable quarterly. These loans are used to finance receivables and inventories on a seasonal basis, bank loans are zero in the off-season.

The long-term debt consists of 30-year, semiannual payment mortgage bonds with a coupon rate of 10%. Currently, these bonds provide a yield to investors of rd= 12%. If new bonds were sold, they would have a 12% yield to maturity.

TII's perpetual preferred stock has a $100 par value, pays a quarterly dividend of $1.50, and has a yield to investors of 10%. New perpetual preferred would have to provide the same yield to investors, and the company would incur a 7% flotation cost to sell it.

The company has 4 million shares of common stock outstanding. P0 = $20, but the stock has recently traded in price the range from $17 to $23. D0 = $1 and EPS0 = $2. ROE based on average equity was 23% in 2008, but management expects to increase this return on equity to 30%; however, security analysts and investors generally are not aware of management's optimism in this regard. Betas, as reported by security analysts, range from 1.3 to 1.7; 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 brokerage house analysts reports forecast dividend growth rates in the range of 10% to 15% over the foreseeable future.

TII's financial vice president recently polled some pension fund investment managers who hold TII's securities regarding what minimum rate of return on TII's common would make them willing to buy the common rather than TII bonds, given that the bonds yielded 12%. The responses suggested a risk premium over TII bonds of 4 to 6 percentage points.

TII is in the 35% federal-plus-state tax bracket. TII's principal investment banker predicts a decline in interest rates, with rd falling to 10% and the T-bond rate to 5%, although the bank acknowledges that an increase in the expected inflation rate could lead to an increase rather than a decrease in interest rates. Assume that you were recently hired by TII 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. Your cost of capital should be appropriate for use in evaluating projects that are in the same risk class as the assets TII now operates. Do not round intermediate steps. Round your answer to two decimal places.