Question

PLEASE SHOW ALL WORK ON PAPER (So I can understand the steps)

Problem 4 Assume the following: T-Bill rate = 1%, Market Risk Premium = 9%, Tax rate = 20%, Beta = 2 Stock Price = $82/per share Current Dividend = $2.75 (growth rate = 5%) Shares outstanding 100 million. Total bonds =10.526 million bonds. Price of each bond = 950 Cost of Debt = 5.15%. (a): Find the cost of equity using CAMP and the dividend growth model. Calculate their average. (b): Calculate the capital structure weights (c): Calculate the WACC.

Answer 1

a

As per CAPM

expected return = risk-free rate + beta * (Market risk premium)

Expected return% = 1 + 2 * (9)

Expected return% = 19

Price = recent dividend* (1 + growth rate )/(cost of equity - growth rate)

82 = 2.75 * (1+0.05) / (Cost of equity - 0.05)

Cost of equity% = 8.52

Average = (19+8.52)/2 = 13.76%

b

MV of equity=Price of equity*number of shares outstanding

MV of equity=82*100000000

=8200000000

MV of Bond=Par value*bonds outstanding*%age of par

MV of Bond=1000*10526000*0.95

=9999700000

MV of firm = MV of Equity + MV of Bond

=8200000000+9999700000

=18199700000

Weight of equity = MV of Equity/MV of firm

Weight of equity = 8200000000/18199700000

W(E)=0.4506

Weight of debt = MV of Bond/MV of firm

Weight of debt = 9999700000/18199700000

W(D)=0.5494

c

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 5.15*(1-0.2)

= 4.12

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=4.12*0.5494+13.76*0.4506

WACC =8.46%