Milwaukee Telecom (MT) reports the following items on its financial statements:

• $300 million of 18-year bonds with a coupon rate of 6.34% p.a. with interest paid semiannually. The company has a BB credit rating. Companies with similar credit ratings are currently paying a premium of 240 basis points (2.40%) above the yield on U.S. Treasury bonds (the risk-free rate) of 1.50% p.a. on 18-year bonds. The company faces a marginal tax rate of 22 percent.
• $200 million of 5-year convertible bonds with a coupon rate of 2.30% p.a. with interest paid semiannually. Current market yields on 5-year straight bonds for other companies with BB credit ratings is 3.28% p.a. The bonds were recently valued by a Wall Street analyst at $1,175 per $1,000 bond.
• $121 million of leases (lease obligations averaging $23 million per year over the next 6 years).
• 1,200,000 shares of $100 par value preferred stock paying an annual dividend of $8.75 per share. The stock was recently valued by a Wall Street analyst at $136 per share.
• $1,259 million in common equity (i.e., the sum of the common stock, additional paid-in capital, and retained earnings accounts) with 84 million shares of common stock outstanding. The consensus of Wall Street analysts values the stock at $25 per share.
• Options on 30 million shares of common stock held by managers and employees of the company A footnote to the financial statements indicates the options are valued at $3.60 per share.

Calculate the following items, given the information provided:

1. The book value of each capital item and the book value weights of the company’s capital structure. Note that only the bonds, convertible debt, leases, preferred stock, and common equity are reported on the balance sheet and would thus have book values.
2. The market value of the company’s bonds, convertible debt (separated into debt and equity components), leases (same as their book value), preferred stock, common stock, and stock options. Determine the market value weights of the company’s capital structure.
3. The company’s after-tax cost of debt, cost of preferred stock, and cost of common equity. To find the cost of common equity, use the leveraged beta approach and the book value weights of the company’s straight debt, convertible debt (note this amount is reported as debt on the balance sheet), leases, and total equity. Total equity equals the reported amounts of common equity and preferred stock. The stock is not publicly traded but data from comparable companies showed an average beta of 1.38, an average debt-equity ratio of 0.88, and an average tax rate of 27 percent. MT just paid a dividend (D₀) of $2.57 per share and future dividends are expected to grow at a rate of 2.5% per year indefinitely. The risk-free rate is 1.50% p.a. and the expected return on the S&P 500 is 8.85% p.a.
4. The company’s cost of equity using the leveraged beta approach and the market value weights of total debt and equity. Total debt would be the sum of the market value of the straight debt, the leases, and the debt component of the convertible bonds. Total equity would be the sum of the market value of the common stock, the preferred stock, the stock options, and the equity component of the convertible bonds.
5. The weighted average cost of capital (WACC) using 1) the book value weights determined in part a, and the costs of capital determined in part c, 2) the market value weights determined in part b, and the costs of capital determined in part c, and 3) the market value weights determined in part b, and the costs of capital determined in part c, substituting the cost of equity found in part d for the cost of equity originally determined in part c.

Answer rating: 100% (QA)

Book value of each capital item Bonds 300 million Convertible debt 200 million Leases 121 million Pr... View the full answer