Question

Answer the following all part of one question

4. You are a financial manager of a firm and are asked to assess the cost of capital of your firm.

You know that Your firm is going to pay dividend $1 per share in the next year.

The current stock price is $10 per share

Firm beta is 20% higher than market average

Constant growth rate is 3%

Expected market return is 12% and risk free rate is 2%

There is totally 10 million of outstanding shares of stocks, and for each dollar equity,

firm issued $1.5 debt

Cost of borrowing/issuing bond is 5%

Corporate tax rate 30%

a.

What is the cost of equity (common stock) using the dividend growth model?

b. What is the cost of equity (common stock) using the CAPM model

c.

What is the total value of the stock? What is the total value of the bond? What is the total value of the

firm?

d. What is the WACC for your firm using the cost of equity from CAPM?

Answer 1

(a)

Compute the cost of equity (Ke), using the equation as shown below:

Ke = (Next dividend/ Stock price) + Growth rate

      = ($1/ $10) + 3%

      = 13%

Hence, the Ke is 13%.

(b)

The beta of the market is always 1, the firm beta is 20% higher than market beta. Hence, the beta of the firm is 1.20.

Compute the cost of equity (Ke), using the equation as shown below:

Ke = Risk free rate + {Beta*(Market rate – Risk free rate)}

      = 2% + {1.2*(12% - 2%)}

      = 14%

Hence, the Ke is 14%.

(c)

Compute the value of equity, using the equation as shown below:

Value of equity = Shares outstanding*Stock price

                          = 10 million*$10

                          = $100 million

Hence, the value of equity is $100 million.

Compute the value of debt, using the equation as shown below:

Value of debt = Shares outstanding*Share price*Bond price per dollar

                       = 10 million*$10*$1.50

                       = $150 million

Hence, the value of debt is $150 million.

Compute the value of the firm, using the equation as shown below:

Value of firm = Value of equity + Value of debt

                       = $100 million + $150 million

                       = $250 million

Hence, the value of the firm is $250 million.     

(d)

Compute the cost of debt (Kd), using the equation as shown below:

Kd = Interest*(1 – Tax rate)

      = 5%*(1 – 0.30)

      = 3.5%

Hence, the Kd is 3.5%.

Compute the weighted average cost of capital (WACC), using the equation as shown below:

WACC = (Ke*Value of equity/ Total value) + (Kd*Value of debt/ Total value)

             = (14%*$100 million/ $250 million) + (3.5%*$150 million/ $250 million)

             = 5.6% + 2.1%

             = 7.7%

Hence, the WACC is 7.7%.