## Question

Debt that pays $1 million coupons a year and $18 million maturity value after 10 years will sell for $20 million.

Equity that pays expected dividends of $1.2 million starting next year and growing at a rate of 3 percent per year thereafter sells for $10 million.

Question 12: Calculate the cost of debt, equity, and the WACC.

Before starting your calculations, review the following materials:

Cost of capital and choice of financing

Equity, debt, and preferred stock

Finally, your firm has decided to spin off Android01 and Processor01 as a separate firm. The owners of the new firm will be equity holders and debt holders. After speaking with potential investors, investment banks have identified two possible capital structures (structure of equity and debt ownership):

Debt holders receive debt that pays them coupons of $2 million a year, and $30 million after 20 years (these are expected values as the coupons and principal payments are not riskless, the debt buyers realize the firms could default). They price the debt using a discount rate of 4 percent. Equity holders receive expected dividends of $3 million starting from year 5, and growing at a rate of 4 percent per year (a growing perpetuity). They price the equity using a discount rate of 7.5 percent.

Debt holders receive debt that pays them coupons of $1 million a year, and $12 million after 20 years (these are expected values as the coupons and principal payments are not riskless, the debt buyers realize the firms could default). They price the debt using a discount rate of 3.5 percent. Equity holders receive expected dividends of $3.9 million starting from year 5, and growing at a rate of 4.5 percent per year (a growing perpetuity). They price the equity using a discount rate of 7 percent.

Your firm receives all the proceeds from the sale debt and equity. Since the firm is selling debt and equity, it wants to sell using the capital structure that provides them with the most money (sum of whatever debt and equity sells for).

Prepare a Capital Budgeting and Cost of Capital report that answers the following Question 13.

Question 13: Which particular capital structure should be chosen for the spin-off?

Here. the firm is the seller of a physical asset for which it gets all the money today. Therefore you do not have to calculate NPV etc. It is not making an investment it is receiving money by selling the subsidiary. You have to calculate the price at which debt sells and the price at which equity sells. You have to calculate the price of debt using the annuity formula and the price of equity using the growing perpetuity formula. Then add the two to get total money raised by selling subsidiary. Whichever financing gives more total money should be the preferred financing.

Before starting your calculations, review the following materials:

Cost of capital and choice of financing

Equity, debt, and preferred stock

## Solution Preview

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Given thatFor debt

Annual coupons $1,000,000

Maturity value (FV) $18,000,000

Time to maturity 10 years

Current selling price (PV) $20,000,000

Therefore, cost of debt is found using the RATE ( ) function of Excel.

Here, cost of debt 4.17%

As tax rate is not given, I am assuming that the post tax cost of debt and pre tax cost of debt are same for WACC calculations....

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Solution.xlsx.