Question

How can i calculate the cost of equity using Security Market Line and Dividend Discount Model (DDM), the cost of debt, the market value weights, and the WACC to use your answer from Security Market Line in your calculation for the cost of equity? Please do not use excel

Phillips Pharmaceuticals Limited (PPL) shares are publicly traded on the Toronto Stock Exchange. The common shares currently trade at a market price of $30.00 per share. PPL recently paid a dividend on its common stock of $1.50 per share. The company maintains a 60% payout policy and has a Return on Equity (ROE) of 10%. The company beta is 0.9. PPL also has long-term bonds trading on public markets. The bonds are currently trading at a quoted price of 96.54. These 5.75% semi-annual bonds have ten years left until they mature. PPL is considering a project that will expand its production facilities. The project is expected to produce annual cash flows before tax of $100,000 for the next eight years. The project is considered to be of similar risk to the risk of the firm itself. It will cost PPL $400,000 this year to get this project up and running. The assets will have no value in 8 years' time. Shuting Tia, PPL's manager of finance, has collected current data from the firm's underwriters. Government of Canada 91-day Treasury bills are currently yielding 4.25%. The expected return on the S&P/TSX Composite Index is forecast to be 10% in the next year New equity capital could be raised by the firm at the current market price, with flotation costs of 4.75% of the value of the issue. New bonds could be sold, with flotation costs of 3.67%. The firm faces a corporate tax rate of 40%. The assets belong in an asset class with a CCA rate of 30%. The company will seek to maintain the current capital structure based on existing market value weights. - Assume flotation costs are expensed at time=0. The firm's most recent financial statements are found below: Phillips Pharmaceuticals Limited. Balance Sheet As at December 31, 20XX Assets Liabilities Cash 100,000 Accruals 30,000 Accounts Receivable 220,000 Accounts Payable 312,000 Inventories 450,000 Total Current Liabilities 342,000 Total Current Assets 770,000 Bonds 5.75% 1,000,000 Gross Fixed Assets 4,000,000 Common stock (100,000 outstanding) 1,000,000 Accumulated Depreciation 1,500,000 Retained earnings 928,000 Net Fixed Assets TOTAL ASSETS 2,500,000 3,270,000 TOTAL LIABILITIES & OWNERS EQUITY 3,270,000

Answer 1

COST OF EQUITY USING SECURITY MARKET LINE:

CAPM Equation:

Rs=Rf+Beta*(Rm-Rf)

Rs=Required Return

Rf=Risk Free Rate=4.25%

Beta=0.9

Rm=Expected Market Return=Expected Index Return=10%

Required Return =Rs=4.25%+0.9*(10-4.25)%=9.425%

FLOTATION COSTS=4.75%=0.0475

Cost of Equity =9.425/(1-0.0475)=9.9%

COST OF EQUITY USING DIVIDEND DISTRIBUTION MODEL:

Sustainable Growth Rate =(1-Payout Ratio)*Return on Equity

Payout ratio =60%=0.6

Return on Equity =10%

g=Sustainable Growth Rate=(1-0.6)*10%=4%=0.04

R=(D1/P0)+g

R=Required Return on Equity

D1=Next Years Dividend=D0*(1+g)

D0= Current Dividend=$1.50

D1=1.50*1.04=$1.56

P0=Current Market Price =$30.00

Required Return on Equity =(1.56/30)+0.04=0.092=9.2%

FLOTATION COSTS=4.75%=0.0475

Cost of Equity =9.2/(1-0.0475)=9.7%

COST OF DEBT:

You will need to use excel to get the cost of debt:It will not be able to calculate without using excel because of complicated equations involved.

Nper=Number of semi annual period left =10*2=20

Pmt = Semi annual Coupon Payment =(1000000*5.75%)/2=$28,750

Pv=Current Market Value =0.9654*1000000=$965,400

Fv=Amount to be paid on maturity after 10 years=$1000000

RATE=Semi annual yield to maturity=3.1% (Using RATE Function of excel with Nper=20, Pmt=28750,Pv=-965400,Fv=1000000)

Annual Yield to maturity =3.1*2=6.2%

The details of using Excel RATE function is attached.

Flotation Cost =3.67%=0.0367

Before tax cost of Debt =6.2/(1-0.0367)=6.4%

Tax Rate=40%=0.4

After Tax Cost of Debt=6.4*(1-0.4)=3.9%

MARKET VALUE WEIGHTS:

Equity =$30*100000 shares=$3,000,000

Debt =Pv=$965,400

Total Market Value=3000000+965400=$3,965,400

Market Value Weight of Equity =3000000/3965400=0.7565

Market Value Weight of Debt =965400/3965400=0.2435

WACC=Weight of Equity*Cost of Equity+Weight of debt*Cost of Debt

WACC=0.7565*9.9%+0.2435*3.9%=8.4%

Clipboard Font Alignment y Number D31 x fc =RATE(D27,028,-D29,030) E F ДА В Nper Pmt Pv FV RATE 32 Number of Semi annual coupons Semi annual Coupon payment Current market Value Payment at maturity Semi annual yield to maturity D 20 $28,750 $965,400 $1,000,000 3.1%!