# Over the last twenty years there has been considerable consolidation in the confectionery...

## Question:

Over the last twenty years there has been considerable consolidation in the confectionery business (e.g the acquisition of Browntree PLC by nestle SA in 1988 and Cadbury by Kraft in 2010). you have a suspicion that a large food manufacturer might try to buy Tootsie Roll. You want to calculate a DCF valuation for Tootsie Roll. The first step in your valuation is to calculate Tootsie Roll's weighted average cost of capital. Using the data provided below, answer the questions that follow and calculate Tootsie Roll's WACC.

1. The risk free rate is 4.25%

2. The expected return on the market portfolio is 8%

3. The corporate tax rate is 40%

4. The face value of Tootsie Roll's outstanding bonds is 2350 million

5. The coupon rate on tootsie roll's bonds is 5%. assume that the bonds pay annual coupons.

6. The yield to maturity on Tootsie Roll's bonds is 7%

7. Tootsie Roll's bonds mature in 13 years.

8. Tootsie Roll has 1700 million common shares outstanding

9. The market price of Tootsie Roll's common shares is 5.85

10. Tootsie Roll's beta is 0.8

a. What is Tootsie Roll's after tax cost of debt?

b. What is Tootsie Rolls cost of equity?

c. What is the market value of long term debt?

d. What is the capital structure weight for equity?

e. What is Tootsie Roll's WACC?

## Long Term Debt:

Long term debt includes bank loans, mortgage, Bond, etc. Long term that has a maturity period of more than one year. Debt capital provides a tax shield for the companies because the interest expense is a tax-deductible item.

## Answer and Explanation:

**Values given:**

Risk free rate = 4.25%

Return on market portfolio = 8%

Tax rate = 40%

Face value = $2,350 million

Coupon rate = 5%

Yield to maturity = 7%

Bonds mature = 13 years.

Shares outstanding = 1,700 million

Market price = $5.85

Beta = 0.8

**Finding:**

**a.**

After tax cost of debt is calculated as follow:

After tax cost of debt = Coupon Rate * (1 - Tax rate)

After tax cost of debt = 5% * (1 - 40%)

After tax cost of debt = 0.05 * (1 - 0.40)

After tax cost of debt = 0.05 * 0.60

After tax cost of debt = 0.03 or 3%

**b.**

Cost of equity is calculated as follow:

Cost of equity = Risk free rate + (Return on market portfolio - Risk free rate) * Beta

Cost of equity = 4.25% + (8% - 4.25%) * 0.8

Cost of equity = 0.0425 + (0.08 - 0.0425) * 0.8

Cost of equity = 0.0425 + (0.0375 * 0.8)

Cost of equity = 0.0425 + 0.03

Cost of equity = 0.0725 or 7.25%

**c.**

Current market value of bond is calculated as follow:

Particulars | Amount ($) |
---|---|

Face value (a) | 2,350 million |

Coupon rate (b) | 5.00% |

Bonds mature | 13 years |

Interest Amount ((c) = (a) * (b)) | 117.5 million |

No of Interest payments | 13 |

YTM | 7% |

Annuity factor for 13 periods at 7% (d) | 8.3577 |

PV of Interest Cash flows ((e) = (c) * (d)) | 982.02 million |

Face value (a) | 2,350 million |

PV factor at 7% for 13 years (f) | 0.4150 |

PV of maturity ((g) = (a) * (f)) | 975.17 million |

Current market value of bond ((h) = (e) + (g)) | 1,957.19 million |

**d.**

Weight of equity is calculated as follow:

Market value of shares = Shares outstanding * Market price

Market value of shares = 1,700 million * 5.85

Market value of shares = $9,945 million

Total capital = Current market value of bond + Market value of shares

Total capital = 1,957.19 million + 9,945 million

Total capital = $11,902.19 million

{eq}Weight \ of \ equity \ = \ \dfrac{Market \ value \ of \ shares}{Total \ capital} \\ Weight \ of \ equity \ = \ \dfrac{9,945 \ million}{11,902.19 \ million} \\ Weight \ of \ equity \ = \ 0.84 {/eq}

**e.**

WACC is calculated as follow:

WACC = (After tax cost of debt * (1 - Weight of equity)) * (Cost of equity * Weight of equity)

WACC = (3% * (1 - 0.84)) * (7.25% * 0.84)

WACC = 0.48% + 6.09%

WACC = 6.57%

#### Learn more about this topic:

from Financial Accounting: Help and Review

Chapter 8 / Lesson 7