Cost of capital Chapter 14 problems Cost of

Cost of capital Chapter 14 problems

Cost of equity D 1: expected dividend for upcoming year Po: current share price g: growth rate

Cost of equity Suppose STC paid a dividend of 4$ per share last year. The stock is currently sells for 60 $ per share. You estimate that the dividend will grow steadily at a rate if 6% per year into the infinite future. What is the cost of equity for STC? Suppose that your company is expected to pay a dividend of $1. 50 per share next year. You bought the common stock for 20 and expect to sell it next year worth $25. What is your required rate of return?

Cost of equity • From the SML comes the Capital Asset Pricing Model (CAPM) • According to the CAPM: RE = Rf + b. E (ERM - Rf) Rf = risk free rate of return Rm = expected market return Rm-RF = market risk premium BE = estimate of systematic risk, the risk for an individual security relative to the market risk as a whole

Suppose your company has an equity beta of. 58 and the current risk-free rate is 6. 1%. If the expected market risk premium is 8. 6%, what is your cost of equity capital?

Ex 1 Page 465 • The Down and Out Co. just issued a dividend of 2. 40$ per share on its common stock. The company is expected to maintain a constant 5. 5 percent growth rate in its dividends indefinitely. If the stock sells for 52$ a share , what is the company’s cost of capital?

Ex 3 Page 465 Stock in Country Road Industries has a beta of 0. 85. the market risk premium is 8 percent, and T-bills are currently yielding 5 percent. The company’s most recent dividend was 1. 6$ per share, and dividends are expected to grow at a 6 percent annual rate indefinitely. If the stock sells for 37$ per share, what is your best estimate of the company’s cost of capital?

Ex 4 Page 465 • Suppose In a Found Ltd. Just issued a dividend of 1. 43$ per share on its common stocks. The company paid dividends of 1. 05$ , 1. 12$, 1. 19$, and 1. 30$ per share in the last four years. If the stock currently sells for 45$, what is your best estimate of the company’s cost of equity?

Cost of debt •

Cost of debt Suppose we have a bond issue currently outstanding that has 10 years left to maturity and a face value of $1, 000. The coupon rate is 10% and coupons are paid annually. The bond is currently selling for $941. What is the cost of debt Rd? To find the cost of debt or the YTM: 1. If the Price is lower than face value Rd= YTM = C +( d/n) (p+F) / 2 C= payment d= decrease in value of bond n= years to maturity p= market value of bond F= face value of bond Rd= YTM= 100 +( 59/10) = 11% (941+1000) / 2

Suppose we have a bond issue currently outstanding that has 10 years left to maturity and a face value of $1, 000. The coupon rate is 10% and coupons are paid annually. The bond is currently selling for $1, 134. What is the cost of debt Rd? 2. If the Price is Higher than face value Rd= YTM = C - ( rs/n) (p+F) / 2 C= payment rs= raise in value of bond n= years to maturity p= market value of bond Rd= YTM = 100 - ( 134/10) = 8% (1134+1000) / 2

Cost of preferred stocks R P = DP / P 0 Rp cost of preferred stock Dp dividends paid Po current price not face value

Cost of preferred stocks • On May 30, 2008 Alabama Power Co. had two issues of ordinary preferred stock with a 25$ par value that traded on the NYSE. One issue paid 1. 30$ annually per share and sold for 21. 05$ per share. The other paid 1. 46$ per share annually and sold for 24. 35$ per share. What is Alabama Power’s cost of preferred stock?

Ex 5 Page 465 • Holdup bank has an issue of preferred stock with a 6$ stated dividend that just sold for 96$ per share. What is the bank’s cost of preferred stock?

Capital Structure Weights • Notation – E = market value of equity = # of outstanding shares times price per share – D = market value of debt = # of outstanding bonds times bond price – V = market value of the firm = D + E • Weights – w. E = E/V = percent financed with equity – w. D = D/V = percent financed with debt

Example: Capital Structure Weights • Suppose you have a market value of equity equal to $500 million and a market value of debt equal to $475 million. – What are the capital structure weights?

Taxes and the WACC • We are concerned with after-tax cash flows, so we also need to consider the effect of taxes on the various costs of capital • Interest expense reduces our tax liability – This reduction in taxes reduces our cost of debt – After-tax cost of debt = RD(1 -TC) • Dividends are not tax deductible, so there is no tax impact on the cost of equity WACC = w. ERE + w. PRP+ w. DRD(1 -TC)

Example • The capital structure of a certain firm consists of 30% debt, 10% preferred stock and 60% common stock. The cost of debt is 10%, preferred stock 12% and 15% for common stock. What is the weighted average cost of capital if you knew that the company pays 40% in taxes?

Example • Company A has issued 10, 000 bonds and 200, 000 common stocks with face values 1000, 50 respectively. The coupon rate for the bonds is 10% and has a 8 year maturity date. The company just paid $6 in dividends which are expected to grow 5% in the upcoming years. The current price for the bonds are $800 and $60 for the common stock. What is the WACC of the company if it pays 35% in taxes?

• The B. B Lean Co. has 1. 4 million shares of stocks outstanding. The stock currently sells for 20$ per share. The firm’s debt is publicly traded and was recently quoted at 93 percent of face value. It has a total face value of 5$ million, and is currently priced to yield 11 percent. The risk free rate is 8 percent, and the market risk premium is 7 percent. You’ve estimated that Lean has a beta of . 74. if the corporate tax rate is 34 percent, what is the WACC of Lean Coo?

Flotation Costs- Basic Approach • The Spatt Company, an all equity firm, has a cost of equity of 20 percent. What is the WACC for this company? • The Spatt is considering a large-scale expansion of 100$ million, this expansion is going to be funded by selling new stocks with flotation costs of 10 percent. What is the amount that Spatt should raise? • Suppose that Spatt’s target capital structure is 60 percent equity, 40 percent debt. The flotation cost of equity is still 10 percent while the flotation cost of debt is 5 percent. What is the amount that Spatt should raise?

Flotation Costs- Basic Approach • ABC co. has a target capital structure that is 80% common equity, 20% debt. The flotation cost for equity issues are 20% of the amount raised; the flotation costs for debt issues are 6%. If the company needs $65 million for a new manufacturing facility, what is the true cost once flotation costs are considered?

Ex 9 Page 465 • Mullineaux Corporation has a target capital structure of 60 percent common stocks, 5 percent preferred stocks, and 35 percent debt. Its cost of equity is 14 percent, the cost of preferred stock is 6 percent, and the cost of debt is 8 percent. The relevant tax rate is 35 percent A. What is the WACC? B. The company’s president has approached you about Mullineaux’s capital structure. He wants to know why the company doesn’t use more preferred stock financing because its costs less than debt. What would you tell the president?

Ex 10 Page 466 • Sixx AM Manufacturing has a target debtequity ratio of 0. 65. its cost of equity is 15 percent, and its cost of debt is 9 percent. If the tax rate is 35 percent, what is the company’s WACC?

Ex 11 Page 466 • Fama’s Llamas has a WACC of 8. 9 percent. The company’s cost of equity is 12 percent, and its pretax cost of debt is 7. 9 percent. The tax rate is 35 percent. What is the company’s target debt-equity ratio?

EX 12 Page 466 • Filer Manufacturing has 11 million shares of common stock out standing. The current share price is 68$, and the book value per share is 6$. Filer Manufacturing also has two bond issues outstanding. The first bond issue has a face value of 70$ million, has a 7 percent coupon, and sells for 93 percent of par. The second issue has a face value of 55$ million, has an 8 percent coupon, and sells for 104 percent of par. The first issue matures in 21 years, the second in 6 years. A. What are Filer’s capital structure weights on a book value biases? B. What are Filer’s capital structure weights on a market value biases? C. Which are more relevant, the book or market value weights? Why?

Ex 18 Page 467 • Suppose your company needs 20$million to build a new assembly line. Your target debt-equity ratio is. 75. the flotation cost for new equity is 8 percent, but the flotation cost for debt is only 5 percent. Your boss decided to fund the project by borrowing money because the flotation costs are lower and the needed fund are relatively small. A. What do you think about the rationale behind borrowing the entire amount? B. What is your company weighted average flotation costs, assuming all equity is raised externally? C. What is the true cost of building the new assembly line after taking flotation costs into account? Does it matter in this case that the entire amount is being raised from debt?

Ex 23 Page 468 • Floyd industries stock has a beta of 1. 5. the company just paid a dividend of. 8$, and the dividends are expected to grow at 5 percent. The expected return of the market is 12 percent, and the Treasury bill are yielding 5. 5 percent. The most recent stock price for Floyd is 61$. A. Calculate the cost of equity using DCF method B. Calculate the cost of equity using SML method C. Why do you think your estimates in (a) and (b) are so different?