Corporation is discussing a new capital expenditure project that requires an investment of €100 million. In line with the target capital structure of Corporation, the management of the company has prepared the following funding plan:

A 5-year zero-coupon bond with face value of €32 million, priced at 80% of its face value.

A 5-year coupon bond, with 4% annual coupons, face value of €26 million, priced at 95% of its face value.

Preferred shares with a total €18 million face value. The issue price is at €40 with a preferred coupon of 12%. The flotation expenses are 2% on the issue price.

The remaining financing needs will be covered from retained earnings. Currently, the stock of the company trades at €50, the last dividend payment was €2.5 per share, and the expected growth rate for dividends is 8 percent. In addition, the beta of the stock is 1.4, the risk-free rate is 4 percent, and the expected market risk premium is 8 percent.

Questions:

1. Estimate the WACC of Corporation under the CAPM and DDM models, considering that the corporate tax rate is 35 percent. (10%)

2. Are the two estimates the same? In case that the two methodologies result to different estimates, how you would explain this? (5%)

3. Assuming that the management of Corporation is conservative, which estimate you would propose to them to apply in this investment project? (5%)

4. Explain briefly how WACC is related to the level of leverage (debt/equity ratio) of a firm. What are the key differences between the main capital structure theories?

Answer rating: 100% (QA)

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