MN7060 Strategic Financial Management

Corporate Finance: Seminar 5

WACC
1. Calculate the weighted-average cost of capital (WACC) for Federated
Junkyards of America, using the following information:
∙ Debt: $75,000,000 book value outstanding. The debt is trading at 90% of book
value. The yield to maturity is 9%.
∙ Equity: 2,500,000 shares selling at $42 per share. Assume the expected rate of
return on Federated’s stock is 18%.
∙ Taxes: Federated’s marginal tax rate is Tc =0.35.

2. Whispering Pines, Inc., is all-equity-financed. The expected rate of return on

the company’s shares is 12%.
a. What is the opportunity cost of capital for an average-risk Whispering Pines
investment?
b. Suppose the company issues debt, repurchases shares, and moves to a 30% debt-
to-value ratio (D/V = 0.30). What will be the company’s weighted-average cost of
capital at the new capital structure? The borrowing rate is 7.5% and the tax rate
is 35%.

3. Suppose Federated Junkyards decides to move to a more conservative debt

policy. A year later its debt ratio is down to 15% (D/V = 0.15). The interest rate
has dropped to 8.6%. Recalculate Federated’s WACC under these new
assumptions. The company’s business risk, opportunity cost of capital, and tax
rate have not changed. Use the three-step procedure explained in Section 19-3.

Merger gains and costs

4. Velcro Saddles is contemplating the acquisition of Pogo Ski Sticks, Inc. The
values of the two companies as separate entities are $20 million and $10 million,
respectively. Velcro Saddles estimates that by combining the two companies, it will
reduce marketing and administrative costs by $500,000 per year in perpetuity.
Velcro Saddles can either pay $14 million cash for Pogo or offer Pogo a 50%
holding in Velcro Saddles. The opportunity cost of capital is 10%.
a. What is the gain from merger?
b. What is the cost of the cash offer?
c. What is the cost of the stock alternative?
d. What is the NPV of the acquisition under the cash offer?
e. What is its NPV under the stock offer?
5. As treasurer of Leisure Products, Inc., you are investigating the possible
acquisition of Plastitoys. You have the following basic data:

Leisure Products Plastitoys

Earnings per share $5.00 $1.50
Dividend per share $3.00 $0.80
Number of shares 1,000,000 600,000
Stock price $90 $20

You estimate that investors currently expect a steady growth of about 6% in

Plastitoys’ earnings and dividends. Under new management this growth rate
would be increased to 8% per year, without any additional capital investment
required.
a. What is the gain from the acquisition?
b. What is the cost of the acquisition if Leisure Products pays $25 in cash for each
share of Plastitoys?
c. What is the cost of the acquisition if Leisure Products offers one share of Leisure
Products for every three shares of Plastitoys?
d. How would the cost of the cash offer and the share offer alter if the expected
growth rate of Plastitoys were not changed by the merger?