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problem: Common stocks of the Threes Company which currently has no debt in its capital structure are trading for $50 a share. Threes has 2 million shares outstanding now. Threes Co. uses the CAPM in determining costs of capital. The (unlevered) equity beta for Threes Co. is 1.25, & the risk free rate & the market portfolio return are expected to be 5% and 13 percent, respectively. Its income tax rate is 35 percent.

Mr. Jack Tripper, the Vice-President of Finance, is thinking to change its financing policy to actively maintain a target debt ratio of 20 percent [or 25% debt to equity ratio] of the levered firm. An investment bank informed him that Threes may be able to issue ten year $1,000 par bonds for 922.05 dollar per bond if it offers 4.0% yearly coupons or for $1,116.92 per bond if it offers 6.5% yearly coupons. Coupons will be paid semiannually. Threes plans to keep refinancing bonds at maturity to effectively make bonds perpetual.

find out: [A] Cost of equity at the target leverage ratio, [B] cost of debt, & [C] the WACC of the Threes Co.

Basic Finance, Finance

  • Category:- Basic Finance
  • Reference No.:- M919278

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