Cotton On Ltd. currently has the following capital structure: Debt: $3,500,000 par value of outstanding bond that pays annually 10% coupon rate with an annual before-tax yield to maturity of 12%. The bond issue has face value of $1,000 and will mature in 20 years.

Answer and Explanation:

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Ordinary shares: $5,500,000 book value of outstanding ordinary shares. Nominal value of each share is $100. The firm plan just paid a $8.50 dividend per share. The firm is maintaining 4% annual growth rate in dividends, which is expected to continue indefinitely.

Preferred shares: 45,000 outstanding preferred shares with face value of $100, paying fixed dividend rate of 12%

The firm's marginal tax rate is 30%.

Required:

a) Calculate the current price of the corporate bond?

b)Calculate the current price of the ordinary share if the average return of the shares in the same industry is 9%?

c) Calculate the current price of the preferred share if the average return of the shares in the same industry is 10%

The computation is shown below:

a. For the current price of the corporate bond

Before that first we have to determine the after tax yield to maturity i.e

After tax YTM = Before tax YTM × (1 - tax rate)

= 12% × ( 1 - 30%)

= 12% × (1 - 0.3)

= 12% × (0.7)

= 8.4%

Now

Price of bond = Interest × PVIFA(YTM%,n) + Redemption value × PVIF(YTM%,n)

Interest = 1000 × 10% = $100

YTM% = 8.4%

n = 20

PVIFA(YTM%,n) = [1 - (1 ÷ (1 + r)^n ÷ r ]

PVIFA(8.4%,20) = [1 - (1 ÷ (1 + 8.4%)^20 ÷ 8.4%]

= [1 - (1 ÷ (1 + 0.084)^20 ÷ 0.084]

= [1-(1 ÷ (1.084)^20 ÷ 0.084]

= [1 - 0.1993 ÷  0.084]

= 0.8007 ÷ 0.084

= 9.5327

PVIF(8.4%,20) = 1 ÷ (1 + 8.4%)^20

= 1 ÷ (1.084)^20

= 0.19926

So, the price of bond is

= $100 × 9.5327 + $1000 × 0.19926

= $953.27 + $199.26

= $1,152.52  

b)Price of stock = Dividend of next year ÷ (Required rate of return - growth rate )

where,

Growth rate = 4%

Required rate of return = 9%

The Dividend of next year = Dividend paid  × (1 +  growth rate)

= 8.50 × (1 + 4%)

= 8.50 × (1 + 0.04)

= 8.50 × (1.04)

= $8.84

Thus the price of the stock is

= $8.84 ÷ (9% - 4%)

= $8.84 ÷ 5%

= $176.80  

c) Price of preference shares is

= Dividend ÷ Required rate of return

where,

Dividend = 100 × 12% = $12

And, the Required rate of return = 10%

So, the price of preference shares is

= 12 ÷ 10%

= $120

answer; ///decision making under risk;