Case Study

Topics: Stock, Stock market, Capital asset pricing model Pages: 5 (1551 words) Published: December 4, 2012
What is the firm’s capital structure?
A mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds.

Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.

A company's proportion of short and long-term debt is considered when analyzing capital structure. When people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered.

In our case, regarding the information from the given case, we have such picture Equity: (Price=$35; Beta=0.95)
Common Stock – 75mln shares
Class B stock – 10mln shares

Short-term Debts (interest bearing)
Domestic borrowings – aim is to fund seasonal working capital requirements Short-term Borrowings
Long-term (2) AA+ bonds

What is firm’s cost of debt?
The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; however, because interest expense is deductible, the after-tax cost is seen most often. This is one part of the company's capital structure, which also includes the cost of equity.

A company will use various bonds, loans and other forms of debt, so this measure is useful for giving an idea as to the overall rate being paid by the company to use debt financing. The measure can also give investors an idea as to the riskiness of the company compared to others, because riskier companies generally have a higher cost of debt.

Let’s see what will be the cost of debt for the Wonder Bar’s company. Types of debt| Cost of debt| Loan Amount| Weights| Wighted rate| | | | | |
Short term debt| 8.20%| 76,132,000 | 0.233439221| 0.019142016| | | | | |
AA+ bond 1| 8.25%| 150,000,000 | 0.459936467| 0.037944759| | | | | |
AA+ bond 2| 8.34%| 100,000,000 | 0.306624312| 0.025571908| | | | | |
Total| | 326,132,000 | 1 | 8.27%| Weighted Cost of debt| | | 8.27%|

What is the firm’s cost of equity?

Cost of equity refers to a shareholder's required rate of return on an equity investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk.In general, there are two ways to determine cost of equity. 

First is the dividend growth model:
Cost of Equity = (Next Year's Annual Dividend / Current Stock Price) + Dividend Growth Rate

Second is the Capital Asset Pricing Model (CAPM):
ra = rf + Ba (rm-rf)
The dividend growth model is simple and straightforward, but it does not apply to companies that don't pay dividends, and it assumes that dividends grow at a constant rate over time. The dividend growth model also quite sensitive to changes in the dividend growth rate, and it does not explicitly consider the risk of the investment.  CAPM is useful because it explicitly accounts for an investment's riskiness and can be applied by any company, regardless of its dividend size or dividend growth rate. However, the components of CAPM are estimates, and they generally lead to a less concrete answer than the dividend growth model does. The CAPM method also implicitly relies on past performance to predict the future.  Let’s Calculate Wonder Bars cost of equity using dividend growth model: There is shown (exhibit 3) that five year growth rate for dividend per share is 12%. We also know that the price of the stock of Wonder Bars is $35...
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