NAME:

REG NO.:

FINANCE II QUIZ 2 9th Feb, 2015

Duration: 60mins Maximum Marks: 20

Answer the questions in the answer booklet only. The question paper is to be submitted along with
the answer sheet. Marks will be awarded for showing all relevant steps. Rough work should be done
at the end of the answer booklet only. Calculators are allowed.

Question:

Part 1: Carl Icahn leads the pack of activist investors in the US. He has been considering selling his stake
in the Family Dollar Stores Inc. He has assigned Emma, a new associate in the Icahn Capital
Management, the task of forecasting FDS’s cash flows, and estimating its cost of capital. Following is
some financial information relevant for the cost of capital calculations on the Family Dollar Stores
compiled by Emma:

Assets
Current assets $38,000,000
Net plant, property, and equipment $101,000,000

Total Assets $139,000,000

Liabilities and Equity

Accounts payable $10,000,000
Accruals $9,000,000
Current maturities of Long-term debt $10,000,000
Current liabilities $29,000,000

Long term debt (30,000 bonds, $1,000 face value) $30,000,000

Total liabilities $59,000,000

Common Stock (Authorized capital -30,000,000 shares, $30,000,000

Shares Outstanding - 10,000,000 shares)
Retained Earnings $50,000,000
Total shareholder’s equity $80,000,000

Total liabilities and shareholder’s equity $139,000,000

Emma has collated the recent stock price data on Family Dollar stores (FDS), and has found that the FDS
stock is currently selling for $3.25 per share.

Additionally she has found that FDS bonds are selling for $889.50 per bond. These bonds have a 7.25
percent annual coupon rate, with semi-annual payments. The bonds mature in twenty years, and the
YTM for these bonds is 8.4%. FDS’s debt has a credit rating of Aa.

The beta for FDS is approximately equal to 1.1. The target capital structure of FDS is 1:1. The yield on a
6-month Treasury bill is 3.5 percent and the yield on a 20-year Treasury bond is 5.5 percent.

The historical return on the stock market is 11.5 percent based on the geometric average, and it is 14.5
per cent based on the arithmetic average. The corresponding historical long term bond yields are 5.5
and 6 based on geometric and arithmetic averages, respectively.

FDS’s corporate tax rate is 40 percent.

a. What is appropriate FDS’s Cost of Equity? 4 marks

b. What is appropriate pre-tax and post-tax cost of debt for FDS Inc? 2 marks
c. What are the capital structure weights relevant for WACC calculation? 2 marks
d. What is the weighted average cost of capital for FDS Inc? 2 marks

Part 2: Family Dollar stores, has a business segment, Last Minute Deals (LMD), and Emma has estimated
that the risk associated with LMD is different from average risk of FDS Inc. To facilitate her analysis, she
has collated the following information on the Eleventh Hour Discounts Inc (EHD).

Beta of EHD is approximately 1.4, and its cost of equity is 13.9%. The D/E ratio for EHD is 3:7. EHD’s bond
is rated A by Moody’s.

e. What is EHD’s appropriate cost of equity? 4 marks

f. What is EHD’s pre-tax and after-tax cost of debt? 2 marks
g. What are the capital structure weights relevant EHD’s WACC Calculation. Explain. 2 marks
h. What is the weighted average cost of capital for EHD? 2 marks

Exhibit I: Corporate Bond Ratings and Corresponding Spreads

Ratings Spreads (over long term Treasury Yields)

AAA 3
AA 3.5
A 4
BBB 4.5
BB 5.25
B 6.25