Question 3 (22 marks) Copper Strike Mining Company (CSMC) needs to raise $55,000,000 for the development of a new mining site and will do so by issuing either new bonds or new preferred shares. If CSMC issues preferred shares or bonds to finance this project, it is estimated that the beta will increase to 1.8. The following outlines the information on these two options:

1. Bonds: Bonds with a face value of $55,000,000. The bonds will pay interest at 8%, which is payable quarterly, and mature in 15 years. Current yield to maturity (YTM) on similar bonds is 8%, compounded quarterly.

2. Preferred shares: 440,000 non-voting preferred shares at $125 per share. The preferred shares will be non-cumulative with an annual dividend of $9.00 per share.

The company has the following issued capital:

1. Bonds issued to RD Mining Inc., a private investor. The bonds have a face value of $59,800,000 and a coupon rate of 7%, payable semi-annually. The bonds mature in 10 years. Similar bonds which are actively traded have a current YTM of 7.5%.

2. There are 200,000 non-voting preferred shares outstanding that pay an annual dividend of $2.40 per share. The dividends are cumulative. Currently, preferred shares with similar risk require a return of 9%. The company tries to pay the dividends on these shares every year and has done so for the last four years.

3. There are 1,000,000 common shares outstanding. Recently, the company had a valuation completed which calculated the current market value to be $75 per common share.

4. Management had recent discussions with an investment banker and determined that flotation costs (including legal fees) for private financing will be 6% before tax on new issues of common and preferred shares, and 3% after tax on new issues of debt.

5. CSMCs corporate income-tax rate is 25%.

6. Based on market data, you have determined that the current risk-free rate is 4% and the expected market price of risk is expected to be 7%. You have estimated that the companys beta is 1.7.

CSMC has done no analysis of its optimal capital structure and understands that either of the two options would change its capital structure. The company is interested in knowing how the two options compare to the option of using the companys retained earnings.

Required:

a) Calculate the companys current weighted average cost of capital (WACC) and the WACC under both options. (17 marks)

b) Describe the advantages and disadvantages associated with each of these proposals, including the implications on cash flows and net earnings of either option, and make a recommendation as to which proposal should be accepted. (Note: Calculations of cash flows and net earnings are not required.) (5 marks)

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  Answer ;

  a)

  WACC (Issuance of Debt) = 7.86%

  WACC (Issuance of Preferred shares) = 7.63%

  b)

  	New debt issuance	New preferred shares issuance
  Advantages	The term of loan is only until maturity Has lower issuance cost	"Cheaper" option between the two As the preferred shares to be issued are non-cumulative, the Company has no obligation to pay dividends that are missed due to insufficient cash flows Dividends to preferred share holders does not appear in the income statement and therefore does not affect earnings (it affects retained earnings and cash flows in perpetuity)
  Disadvantages	The Company has to repay the loan's interest and principal throughout the term of the loan otherwise, it could be in default and the bank will have a claim over the collateral identified as part of the loan agreement. Has a yearly effect on the net earnings, cash flows and retained earnings up to the maturity of the loan.	Preferred shares does not have a term (held in perpetuity), thus, payment of dividends on the preferred shares is in perpetuity. Has a higher issuance cost

  Summary: Between the two options, the new debt issuance will include charging an interest expense to the income statement on a yearly basis until the maturity of the loan. This is not the case for the issuance of preferred shares as the issuance of preferred shares does not have an effect on the income statement. Meanwhile, both options affects the cash flows of the company. For the new debt issuance option, this relates to the interest expense paid on a yearly basis and the payment of principal at the maturity date of the loan while for the preferred shares option, it refers to the dividend payment in perpetuity.

  In general, while the preferred share option is the cheaper option and does not have an effect on the net income, the recommendation is to issue new debt as the new debt has a maturity and the payment of interest is not forever.

  Explanation :

  a)

  Notes prior to calculations:

  - Cost of debt and cost of preferred shares does not take into account the one-time cost in issuance of the debt or preferred shares.

  To calculate the WACC, the general formula to use is WACC = (%weight Equity * Cost of equity) + (%weight Debt * After-tax Cost of Debt) + (%weight Preferred shares * Cost of preferred shares)

  Cost of Equity is derived from the CAPM formula and is calculated as Ke = 4% + 1.8 (7% - 4%) = 9.40%

  Cost of Debt varies per option:

  Cost of Debt (issuance of new debt scenario) = (value of old debt/value of total debt) * after-tax cost of debt (old) + (value of new debt/value of total debt) * after-tax cost of debt (new)

  After tax cost of debt (issuance of new debt scenario) = [(57,722,517/112,722,517) * (7.5% * (1 - 25%))] + [55,000,000/112,722,517) * (8% * (1 - 25%)] = 6.78%

  *Valuation of the old debt should be based on the prevailing YTM and the applicable weights is also based on the market value of the debt at the time of valuation.

  After tax cost of debt (issuance of preferred shares scenario) = 7.5% (1 - 25%) = 5.63%

  Cost of Preferred Shares

  Cost of preferred shares (issuance of new debt scenario) = 9% (given)

  Cost of preferred shares (issuance of new preferred shares scenario) = [(value of new pref shares / value of total pref shares) * cost of preferred shares (new)] + [(value of old pref shares / value of total pref shares) * cost of preferred shares (old) =

  [(55,000,000/60,333,333) * 7%) + (5,333,333/60,333,333) * 9%)] = 7.36%

  *Value of old preferred shares is derived by calculating price based on Dividend / r = 2.40 / 9% = 26.67. The value is therefore 26.67 * 200,000 = 5,333,333

  WACC

  	Issue new debt option	Issue pref shares option
  Common stock	75,000,000	75,000,000
  Old pref	5,333,333	5,333,333
  New pref		55,000,000
  Old debt	57,722,517	57,722,517
  New debt	55,000,000
  Total capital	193,055,851	193,055,851
  E weight (Total value of equity / Total capital)	39%	39%
  D weight (Total value of debt / Total capital)	58%	30%
  P weight (Total value of preferred shares / Total capital)	3%	31%
  Cost of equity	9.40%	9.40%
  Cost of debt after-tax	6.78%	5.63%
  Cost of pref	9.00%	7.36%
  Equity (A)	3.65%	3.65%
  Debt (B)	3.96%	1.68%
  Preferred shares	0.25%	2.30%
  WACC (A+B+C)	7.86%	7.63%

After tax cost of debt (issuance of new debt scenario) = [(57,722,517/112,722,517) * (7.5% * (1 - 25%))] + [55,000,000/112,722,517) * (8% * (1 - 25%)] = 6.78% How did they get the valuation of old debt to be 57,722,517

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