WACC Estimation

The table below gives the balance sheet for Travellers Inn Inc. (TII), a company that

was formed by merging a number of regional motel chains.

Travellers Inn: (Millions of Dollars)

Cash $10 Accounts payable $ 10

Accounts receivable 20 Accruals 10

Inventories 20 Short-term debt 5

Current assets $ 50 Current liabilities $ 25

Net fixed assets 50 Long-term debt 30

Preferred stock 5

Common equity

Common stock $ 10

Retained earnings 30

Total common equity $ 40

Total assets $100 Total liabilities and equity $100

The following facts also apply to TII.

(1) Short-term debt consists of bank loans that currently cost 10%, with interest payable quarterly. These loans are used to finance receivables and inventories on a seasonal basis, so bank loans are zero in the off-season.

(2) The long-term debt consists of 20-year, semiannual payment mortgage bonds with a coupon rate of 8%. Currently, these bonds provide a yield to investors of rd =12%. If new bonds were sold, they would have a 12% yield to maturity.

(3) TIIs perpetual preferred stock has a $100 par value, pays a quarterly dividend of $2, and has a yield to investors of 11%. New perpetual preferred stock would have to provide the same yield to investors, and the company would incur a 5% flotation cost to sell it.

(4) The company has 4 million shares of common stock outstanding. P0 = $20, but the stock has recently traded in the price range from $17 to $23. D0 = $1 and EPS0 = $2. ROE based on average equity was 24% in the most recent year, but management expects to increase this return on equity to 30%; however, security analysts and investors generally are not aware of managements optimism in this regard.

(5) Betas, as reported by security analysts, range from 1.3 to 1.7; the T-bond rate is 10%; and RPM is estimated by various brokerage houses to be in the range from 4.5% to 5.5%. Some brokerage house analysts report forecasted growth dividend growth rates in the range of 10% to 15% over the foreseeable future.

(6) TIIs financial vice president recently polled some pension fund investment managers who hold TIIs securities regarding what minimum rate of return on TIIs common would make them willing to buy the common rather than TII bonds, given that the bonds yielded 12%. The responses suggested a risk premium over TII bonds of 4 to 6 percentage points.

(7) TII is in the 40% federal-plus-state tax bracket.

(8) TIIs principal investment banker predicts a decline in interest rates, with rd falling to 10% and the T-bond rate to 8%, although the bank acknowledges that an increase in the expected inflation rate could lead to an increase rather than a decrease in interest rates.

Assume that you were recently hired by TII as a financial analyst and that your boss, the treasurer, has asked you to estimate the companys WACC under the assumption that no new equity will be issued. Your cost of capital should be appropriate for use in evaluating projects that are in the same risk class as the assets TII now operates.

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