Financial Management Unit 6 Assignment (all printed) Flashcards
The Holmes Company’s currently outstanding bonds have a 9% coupon and a 14% yield to maturity. Holmes believes it could issue new bonds at par that would provide a similar yield to maturity. If its marginal tax rate is 25%, what is Holmes’ after-tax cost of debt? Round your answer to two decimal places
…………………………………………………………………………….?
The after-tax cost of debt is calculated as the yield to maturity multiplied by (1 - tax rate).
In this case, the yield to maturity is 14% and the tax rate is 25%.
So, the after-tax cost of debt =
14% * (1 - 0.25) = 10.5%
Therefore, Holmes’ after-tax cost of debt is 10.5%
Torch Industries can issue perpetual preferred stock at a price of $55.50 a share. The stock would pay a constant annual dividend of $5.50 a share. What is the company’s cost of preferred stock, rp? Round your answer to two decimal places …………………………………………………………………………….?
The cost of preferred stock (rp) is calculated by dividing the annual dividend by the price per share.
In this case, the annual dividend is $5.50 and the price per share is $55.50.
So, rp = $5.50 / $55.50 = 0.099 or
9.9% when expressed as a percentage.
Therefore, Torch Industries’ cost of preferred stock is 9.9%
Pearson Motors has a target capital structure of 40% debt and 60% common equity, with no preferred stock. The yield to maturity on the company’s outstanding bonds is 12%, and its tax rate is 25%. Pearson’s CFO estimates that the company’s WACC is 12.80%. What is Pearson’s cost of common equity
…………………………………………………………………………….?
WACC =
Cost of Debt * Proportion of Debt * (1 - Tax Rate)) + (Cost of Equity * Proportion of Equity)
Given that Pearson’s WACC is 12.80%, the proportion of debt is 40%, the proportion of equity is 60%, the cost of debt is 12%, and the tax rate is 25%, we can rearrange the formula to solve for the cost of equity:
Cost of Equity = (WACC - Cost of
Debt * Proportion of Debt * (1 - Tax Rate)) / Proportion of Equity Cost of Equity =
(12.80% - 12% * 40% * (1 - 25%)) / 60%
Cost of Equity = (12.80% - 3.6%) / 60%
Cost of Equity = 9.2% / 60%
Cost of Equity = 15.33%
Therefore, Pearson’s cost of common equity is 15.33%.
Jarett & Sons’ common stock currently trades at $32.00 a share. It is expected to pay an annual dividend of $1.75 a share at the end of the year (D1 = $1.75), and the constant growth rate is 4% a year.
A) What is the company’s cost of common equity if all of its equity comes from retained earnings? Do not round intermediate calculations. Round your answer to two decimal places
B) If the company issued new stock, it would incur a 12% flotation cost. What would be the cost of equity from new stock? Do not round intermediate calculations
…………………………………………………………………………….?
A) The cost of common equity can be calculated using the Gordon
Growth Model, which is:
Cost of Equity = D1 / PO + g
where:
D1 = expected annual dividend = $1.75
PO = current stock price = $32.00
g = constant growth rate = 4% = 0.04
So, Cost of Equity = $1.75 / $32.00 + 0.04 = 0.0546875 + 0.04 =
0.094688
When expressed as a percentage and rounded to two decimal places, the cost of equity is 9.47%
Therefore, Jarett & Sons’ cost of common equity is 9.47%
B) The cost of new equity can be calculated by adjusting the Gordon Growth Model to account for the flotation cost. The formula is:
Cost of New Equity = (D1 / (PO * (1 - Flotation Cost))) + g
where:
D1 = expected annual dividend = $1.75
PO = current stock price = $32.00
g = constant growth rate = 4%= 0.04
Flotation Cost = 12% = 0.12
So,
Cost of New Equity = ($1.75 / ($32.00 * (1 - 0.12))) + 0.04 = 0.102145
When expressed as a percentage and rounded to two decimal places, the cost of new equity is
10.21%
Therefore, the cost of equity from new stock would be 10.21%
Midwest Water Works estimates that its WACC is 10.44%. The company is considering the following capital budgeting projects.
Assume that each of these projects is just as risky as the firm’s existing assets and that the firm may accept all the projects or only some of them. Which set of projects should be accepted …………………………………………………………………………….?
Project A) In this case, Project A has a rate of return of 12.0%, which is higher than the company’s WACC of 10.44%. Therefore, Midwest Water Works should accept
Project A.
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project B) Project B has a rate of return of 11.5%, which is also higher than the company’s WACC of 10.44%.
Therefore, Midwest Water Works should also accept Project B.
In general, any project with a rate of return higher than the company’s WACC will add value to the company and should be considered for acceptance.
________________________________________________________________
project C) rate of return 11.2%, WACC 10.44% Accept
________________________________________________________________
project D-G Same concept; rate of return lower than WACC don’t accept, if rate of return is higher than the WACC accept
The future earnings, dividends, and common stock price of Callahan Technologies Inc. are expected to grow 6% per year. Callahan’s common stock currently sells for $28.25 per share; its last dividend was $2.50; and it will pay a $2.65 dividend at the end of the current year.
part 1 of 4
a) Using the DCF approach, what is its cost of common equity?
…………………………………………………………………………….?
a) The cost of common equity can be calculated using the Gordon Growth Model, which is a version of the Dividend Discount Model (DDM). The formula is:
Cost of Equity = (Dividends per
share / Current Market Value per share) + Growth Rate of Dividends
Given the information:
Dividends per share (D1) = $2.65
(dividend at the end of the current year)
Current Market Value per share
(PO) = $28.25
Growth Rate of Dividends (g) = 6% or 0.06
Substituting these values into the formula:
Cost of Equity = ($2.65 / $28.25) + 0.06 = 0.153805/15.38
The future earnings, dividends, and common stock price of Callahan Technologies Inc. are expected to grow 6% per year. Callahan’s common stock currently sells for $28.25 per share; its last dividend was $2.50; and it will pay a $2.65 dividend at the end of the current year.
part 2 of 4
b) If the firm’s beta is 1.8, the risk-free rate is 6%, and the average return on the market is 13%, what will be the firm’s cost of common equity using the CAPM approach …………………………………………………………………………….?
b) The cost of common equity can be calculated using the Capital Asset Pricing Model (CAPM). The formula is:
Cost of Equity = Risk-free rate + Beta * (Market Return - Risk-free rate)
Given the information:
Risk-free rate (Rf) = 6% or 0.06
Beta (b) = 1.8
Market Return (Rm) = 13% or 0.13
Substituting these values into the formula:
Cost of Equity = 0.06 + 1.8 * (0.13 - 0.06)= 0.186/18.60
The future earnings, dividends, and common stock price of Callahan Technologies Inc. are expected to grow 6% per year. Callahan’s common stock currently sells for $28.25 per share; its last dividend was $2.50; and it will pay a $2.65 dividend at the end of the current year.
part 3 of 4
c) If the firm’s bonds earn a return of 11%, based on the bond-yield-plus-risk-premium approach, what will be rs? Use the judgmental risk premium of 4% in your calculations …………………………………………………………………………….?
The bond-yield-plus-risk-premium approach is a method used to estimate the cost of equity (rs).
The formula is:
Cost of Equity (rs) = Bond yield + Risk premium
Given the information:
Bond yield = 11% or 0.11
Risk premium = 4% or 0.04
Substituting these values into the formula:
Cost of Equity (rs) = 0.11 + 0.04 = 15%
The future earnings, dividends, and common stock price of Callahan Technologies Inc. are expected to grow 6% per year. Callahan’s common stock currently sells for $28.25 per share; its last dividend was $2.50; and it will pay a $2.65 dividend at the end of the current year.
part 4 of 4
If you have equal confidence in the inputs used for the three approaches, what is your estimate of Callahan’s cost of common equity
…………………………………………………………………………….?
The cost of common equity can be estimated by taking the average of the results from the three approaches: the Dividend Discount
Model (DDM), the Capital Asset Pricing Model (CAPM), and the bond-yield-plus-risk-premium approach.
From the previous calculations, we have:
Cost of Equity (DDM) = 15.38%
Cost of Equity (CAPM) = 18.60%
Cost of Equity (bond-yield-plus- risk-premium) = 15%
To find the average, we add these three percentages together and divide by 3:
Average Cost of Equity = (15.39% + 18.60% + 15%) / 3 = 0.1633/16.33%
The Evanec Company’s next expected dividend, D1, is $3.54; its growth rate is 4%; and its common stock now sells for $34.00. New stock (external equity) can be sold to net $32.30 per share.
A)What is Evanec’s cost of retained earnings, rs?
B) What is Evanec’s percentage flotation cost, F?
C) What is Evanec’s cost of new common stock, re?
…………………………………………………………………………….?
A) Gordon Growth Model, which is a version of the Dividend Discount Model (DDM). The formula is:
Cost of Retained Earnings (rs) =
(Dividends per share / Current Market Value per share) + Growth
Rate of Dividends
Given the information:
Dividends per share (D1) = $3.54
(dividend at the end of the current year)
Current Market Value per share (PO) = $34.00
Growth Rate of Dividends (g) = 4% or 0.04
Substituting these values into the formula:
Cost of Retained Earnings (rs) =
($3.54 / $34.00) + 0.04= 0.144118/14.41%
B) The percentage flotation cost (F) is calculated by subtracting the net proceeds per share from the current market price per share, dividing by the current market price per share, and then multiplying by 100 to get the percentage.
Given the information:
Current Market Value per share (PO) = $34.00
Net proceeds per share = $32.30
Substituting these values into the formula:
Percentage Flotation Cost (F) =
(($34.00 - $32.30) / $34.00) * 100= 5
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C) Cost of New Common Stock (re) =
Dividends per share / Net
Proceeds per share) + Growth Rate of Dividends
Given the information:
Dividends per share (D1) = $3.54
(dividend at the end of the current year)
Net Proceeds per share = $32.30
Growth Rate of Dividends (g) = 4% or 0.04
Substituting these values into the formula:
Cost of New Common Stock (re) =
($3.54 / $32.30) + 0.04= 0.149598/14.96
Palencia Paints Corporation has a target capital structure of 35% debt and 65% common equity, with no preferred stock. Its before-tax cost of debt is 8%, and its marginal tax rate is 25%. The current stock price is P0 = $28.00. The last dividend was D0 = $2.25, and it is expected to grow at a 4% constant rate. What is its cost of common equity and its WACC
…………………………………………………………………………….?
common equity (rs)= 12.36%
WACC= 10.13
Common Equity
Cost of Common Equity (rs) =
(Dividends per share / Current
Market Value per share) + Growth
Rate of Dividends
Given the information:
Dividends per share (D1) = $2.25 * (1 + 0.04) = $2.34
(dividend at the end of the current year, considering growth)
Current Market Value per share (PO) = $28.00
Growth Rate of Dividends (g) = 4% or 0.04 Substituting these values into the formula:
Cost of Common Equity (rs) =
($2.34 / $28.00) + 0.04= 0.123571 / 12.36
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WACC) The weighted average cost of capital (WACC) can be calculated using the formula:
WACC =
(Weight of Debt * Cost of Debt * (1 - Tax Rate)) + (Weight of Equity * Cost of Equity)
Given the information:
Weight of Debt = 35% or 0.35
Cost of Debt = 8% or 0.08
Tax Rate = 25% or 0.25
Weight of Equity= 65% or 0.65
Cost of Equity = 12.36% or 0.1236
Substituting these values into the formula:
WACC = (0.35 * 0.08 * (1 - 0.25)) + (0.65 * 0.1236)= 0.10134/10.13
The Paulson Company’s year-end balance sheet is shown below. Its cost of common equity is 17%, its before-tax cost of debt is 9%, and its marginal tax rate is 25%. Assume that the firm’s long-term debt sells at par value. The firm’s total debt, which is the sum of the company’s short-term debt and long-term debt, equals $1,140. The firm has 576 shares of common stock outstanding that sell for $4.00 per share.
Calculate Paulson’s WACC using market-value weights
…………………………………………………………………………….?
First, we need to calculate the market value of equity, which is the number of shares multiplied by the price per share. Given that there are 576 shares selling for $4.00 each, the market value of equity is $2,304
Next, we calculate the market value of debt, which is given as the sum of short-term and long-term debt, $1,140
The total market value of the firm is the sum of the market value of equity and the market value of debt, which is $2,304 + $1,140 = $3,444
The weight of equity is the market value of equity divided by the total market value, which is $2,304 / $3,444 = 0.669
The weight of debt is the market value of debt divided by the total market value, which is $1,140 / $3,444 = 0.331
The weighted average cost of capital (WACC) can be calculated using the formula:
WACC = (Weight of Equity * Cost of Equity) + (Weight of Debt * Cost of Debt * (1 - Tax Rate))
Given the information:
Weight of Equity = 0.669
Cost of Equity = 17% or 0.17
Weight of Debt = 0.331
Cost of Debt = 9% or 0.09
Tax Rate = 25% or 0.25
Substituting these values into the formula:
WACC = (0.669 * 0.17) + (0.331 * 0.09 * (1 - 0.25))= 0.136073 / 13.61
Olsen Outfitters Inc. believes that its optimal capital structure consists of 60% common equity and 40% debt, and its tax rate is 25%. Olsen must raise additional capital to fund its upcoming expansion. The firm will have $3 million of retained earnings with a cost of rs = 13%. New common stock in an amount up to $9 million would have a cost of retained earnings (re) = 16.0%. Furthermore, Olsen can raise up to $4 million of debt at an interest rate of rd = 10% and an additional $6 million of debt at rd = 14%. The CFO estimates that a proposed expansion would require an investment of $5.2 million. What is the WACC for the last dollar raised to complete the expansion?
…………………………………………………………………………….?
First we need to find the amount of equity and debt need to be raised using the below formula
Amount raised by equity = Investment * .60
= 5.2mil * .60
= 3.12
As amount raised is greater than retained earning we need to raise the new equity at cost of equity = 16%
Amount raised by debt = = Investment - amount raise by equity
= 5.2 - 3.12
= 2.08
As this amount is less than 4 million, cost of debt = 10%
We can find WACC for the last dollar raised to complete the expansion using the below formula
WACC = weight of equity * cost of equity + weight of debt * cost of debt * (1 - T Tax rate)
= .60 * 16 + .40 * 10 * (1 - .25)
= 12.6
Empire Electric Company (EEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of rd = 9% as long as it finances at its target capital structure, which calls for 45% debt and 55% common equity. Its last dividend (D0) was $1.75, its expected constant growth rate is 3%, and its common stock sells for $22. EEC’s tax rate is 25%. Two projects are available: Project A has a rate of return of 10%, and Project B’s return is 9%. These two projects are equally risky and about as risky as the firm’s existing assets.
a) What is its cost of common equity
b) What is the WACC?
…………………………………………………………………………….?
a) The cost of common equity (rs) can be calculated using the Gordon Growth Model, which is a version of the Dividend Discount Model (DDM). The formula is:
Cost of Common Equity (rs) =
(Dividends per share / Current Market Value per share) + Growth Rate of Dividends
Given the information:
Dividends per share (D1) = $1.75 * (1 + 0.03) = $1.8025 (dividend at the end of the current year, considering growth)
Current Market Value per share
(PO) = $22
Growth Rate of Dividends (g) = 3% or 0.03
Substituting these values into the formula:
Cost of Common Equity (rs) =
($1.8025 / $22) + 0.03 = 0.111932 / 11.19%
b) The weighted average cost of capital (WACC) can be calculated using the formula:
WACC = (Weight of Debt * Cost of
Debt * (1 - Tax Rate)) + (Weight of
Equity * Cost of Equity)
Given the information:
Weight of Debt = 45% or 0.45
Cost of Debt = 9% or 0.09
Tax Rate = 25% or 0.25
Weight of Equity = 55% or 0.55
Cost of Equity = 11.19% or 0.1119
Substituting these values into the formula:
WACC = (0.45 * 0.09 * (1 - 0.25)) + (0.55 * 0.1119) = 9.19
Travis Industries plans to issue perpetual preferred stock with an $11.00 dividend. The stock is currently selling for $96.00, but flotation costs will be 8% of the market price, so the net price will be $88.32 per share. What is the cost of the preferred stock, including flotation?
…………………………………………………………………………….?
The cost of preferred stock (rp) can be calculated using the formula:
Cost of Preferred Stock (rp) =
Dividends per share / Net Proceeds per share
Given the information:
Dividends per share = $11.00
Net Proceeds per share = $88.32
Substituting these values into the formula:
Cost of Preferred Stock (rp) =
$11.00 / $88.32 = 12.45
The company estimates that it can issue debt at a rate of rd = 11%, and its tax rate is 25%. It can issue preferred stock that pays a constant dividend of $6.00 per year at $51.00 per share. Also, its common stock currently sells for $45.00 per share; the next expected dividend, D1, is $5.25; and the dividend is expected to grow at a constant rate of 5% per year. The target capital structure consists of 75% common stock, 15% debt, and 10% preferred stock.
part 1 of 2
A) What is the cost of each of the capital components
…………………………………………………………………………….?
A)
a. The cost of each of the capital components can be calculated as follows:
1. Cost of Debt (rd): The company can issue debt at a rate of rd =11%. However, the interest expense is tax-deductible, so the after-tax cost of debt is
rd * 1 - Tax Rate = 11% * (1 - 0.25) = 8.25%
- Cost of Preferred Stock (r): The cost of preferred stock is the dividend rate, which is the dividend divided by the price per share. So, rp = Dividend / Price = $6.00 / $51.00 = 11.76%
- Cost of Common Stock (rs): The cost of common stock can be calculated using the Gordon
Growth Model, which is rs = D1 / P0 + 9, where D1 is the expected dividend, P0 is the current stock price, and g is the growth rate. So, rs = $5.25 / $45.00 + 0.05 = 16.67%
The following table gives Foust Company’s earnings per share for the last 10 years. The common stock, 8.4 million shares outstanding, is now (1/1/22) selling for $56.00 per share. The expected dividend at the end of the current year (12/31/22) is 40% of the 2021 EPS. Because investors expect past trends to continue, g may be based on the historical earnings growth rate. (Note that 9 years of growth are reflected in the 10 years of data.)
The current interest rate on new debt is 11%; Foust’s marginal tax rate is 25%; and its target capital structure is 55% debt and 45% equity.
Calculate Foust’s after-tax cost of debt
…………………………………………………………………………….?
The after-tax cost of debt can be calculated using the formula:
After-tax cost of debt = rd * (1 - Tax Rate)
Where:
rd = Interest rate on new debt = 11% or 0.11
Tax Rate = 25% or 0.25
So, after-tax cost of debt = 0.11 * (1 - 0.25)
First, calculate 1 - 0.25= 0.75
Then, multiply 0.11 * 0.75 to get 0.0825 or 8.25%
The following table gives Foust Company’s earnings per share for the last 10 years. The common stock, 8.4 million shares outstanding, is now (1/1/22) selling for $56.00 per share. The expected dividend at the end of the current year (12/31/22) is 40% of the 2021 EPS. Because investors expect past trends to continue, g may be based on the historical earnings growth rate. (Note that 9 years of growth are reflected in the 10 years of data.)
The current interest rate on new debt is 11%; Foust’s marginal tax rate is 25%; and its target capital structure is 55% debt and 45% equity
Calculate Foust’s cost of common equity. Calculate the cost of equity as rs = D1/P0 + g
…………………………………………………………………………….?
The cost of common equity (rs) can be calculated using the Gordon Growth Model, which is:
rs = D1 /P0 + g
Where:
D1 = Expected dividend = 40% of the 2021 EPS =
0.40 * $7.80 = $3.12
P0 = Current stock price = $56.00
The growth rate (g) can be calculated using the formula:
g = [(Ending EPS / Beginning EPS) ^ (1 / Number of Years)] - 1
In this case, the ending EPS is the EPS in 2021 ($7.80), the beginning EPS is the EPS in 2012 ($3.90), and the number of years is 9 (2021 -2012)
So, g = [(7.80 / 3.90) ^ (1 / 9)] - 1
= 0.080060
NEXT,
rs = $3.12 / $56.00 + 0.080060
= 0.135774 / 13.58
