Question

A company has the following capital structure.

• 50,000 shares of common stocks outstanding, trading at Pcs,0 = $10 per share.

• 20,000 shares of preferred stocks trading at Pps,0 = $5 per share, that pays a 0.5 dollar dividend per share.

• The company also sold a 20-year non-amortized corporate bond worth 1 million at par in period 0, with a yield to maturity (YTM) of 5%. The corporation faces a tax rate of τ = 25%.

• The company’s period 0 dividend per share, paid to the common stockholders, is 0.5 dollars and is expected to grow by 10% per year.

Q1: What’s the rate of return expected by the preferred shareholders r_ps?

Q2: According to the Constant Dividend Growth Model, what’s the rate of return required by the common stock shareholder? Denote this number by r_cs,0

Q3: What’s the company’s WACC in period 0?

Q4: In period 1, shortly after dividends are paid to the preferred stockholders, the company borrows a 10-year term amortized bank loan at APR of 5% and uses the proceeds of which to buy back (retire) outstanding preferred stocks at a price of P_ps,1 = 5.25 dollars per share. Following this news, the price of common stocks drops to P_cs,1 = 9.5 dollars per share in period 1.

Based on the information here, answer questions Q4(a), Q4(b), and Q4(c).

Q4a: What’s the actual rate of return to an investor who bought one share of preferred stock in period 0, and sells it back to the company in period 1?

Q4b: The financial market now believes that the company will deliver a dividend growth rate of 12% in the future. According to the Constant Dividend Growth Model, what’s the rate of return required by the common stock shareholder in period 1?

Q4c: What’s the company’s WACC in period 1?

Answer 1

Answer to Question 1 & 2

E Answer Question Requried 1 Cost of Preferred Stocks = Dividend / Current Market Price 2/ Requried Rate of Common Stocks = ((DO*(1+g)/Po)+g Answer Formula 10.00% =C9/010 15.50% =((C6*(1+C8))/C7)+C8 $ = Dividend Year O (DO) =Price of Stock (PO) =Growth Rate (g) = Preffered Stock Dividend = Preffered Stock Price 0.50 10.00 10.00% 0.50 5.00 $ $

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