Peter Parker Inc.

Q3.a. Peter Parker Inc. has no debt but can borrow at 5.9%. The firm’s Weighted Average Cost of Capital (WACC) is currently 9.20% and the tax rate is 21%.
i. What is the company’s cost of equity?
ii. If the company converts to 25% debt, what will its cost of equity be?
iii. If the company converts to 50% debt, what will its cost of equity be?
iv. What is the company’s WACC in parts (ii) and part (iii)?

10 marks
Q3.b. Suppose your company needs to raise $65 million and you want to issue 20-year bonds for this purpose. Assume the required return on your bond issue will be 4.9%, and you’re evaluating two alternative issues: (1) a semi-annual coupon bond with a coupon rate of 4.9%; and (2) a zero-coupon bond. The tax rate is 21%. Both bonds will have a par value of $1,000.
i. How many of the coupon bonds would you need to issue to raise the $65 million? How many of the zeroes would you need to issue?
ii. In 20 years, what will your company’s repayment be if you issue the coupon bonds? What if you issue the zeroes?
iii.Based in your answers in parts (i) and (ii), provide explanations why would you ever want to issue the zeroes? To answer, calculate the firm’s after-tax cash outflows for the first year under the two scenarios. Assume the Tax Office’s amortization rules apply for the zero-coupon bonds.
Hint: (1) For the cash flow of the coupon bonds, we need to account for the tax deductibility of the interest payments. (2) For the zero-coupon bonds, the first-year interest payment is the difference in the price of the zero at the end of the year and the beginning of the year. The total cash flow for the zeroes will be the interest deduction for the year times the number of zeroes sold, times the tax rate.