HOMEWORK2

Chapter 7

7. Current and projected free cash flows for Radell Global Operations are shown below.

Growth is expected to be constant after 2015, and the weighted average cost of capital is 11%. What is the horizon (continuing) value at 2016 if growth from 2015 remains constant?

Answer:

Growth in 2014= (667.5-606.82)/606.82 x 100 =10%

Growth in 2015= (707.55-667.5)/ 667.5 x 100 =6%

Growth in 2016= (750-707.5)/ 707.5 x 100 =6%

K=11% g=6%

Continuing value at 2015= 750/ (k-g) =15000

9. Crisp Cookware’s common stock is expected to pay a dividend of $3 a share at the end of this year (D1= $3.00); its beta is 0.8; the risk-free rate is 5.2%; and the market risk premium is 6%. The dividend is expected to grow at some constant rate g, and the stock currently sells for $40 a share. Assuming the market is in equilibrium, what does the market believe will be the stock’s price at the end of 3 years (i.e., what is P3^)? Answer:

Required Rate of Return = Risk Free Rate + Beta*(Market Premium)

Required Rate of Return = 5.2 + .8*(6) = 10%

Current Stock Price (Po) = D1/ (ke - g)

D1 = 3

ke = 10%

g =?

40 = 3/ (.10 - g)

40*.10 - 40g = 3

g or growth rate = (4-1)/40 = .025 or 2.5%

P3 = D4/ (ke - g) = 3*(1+.025) ^3/ (.10 - .025) = 42.076

Answer is 42.08.

14. Several years ago, Rolen Riders issued preferred stock with a stated annual dividend of 10% of its $100 par value. Preferred stock of this type currently yields 8%. Assume dividends are paid annually.

a. What is the estimated value of Rolen’s preferred stock?

b. Suppose interest rate levels have risen to the point where the preferred stock now yields 12%. What would be the new estimated value of Rolen’s preferred stock? Answer:

Dividend = 100 * 10% = 10

a. current yield = dividend/current price

8% = 10/current price current price = 10/8% = 125

b. current yield = dividend/current price

11% = 10/current price current price = 10/11% = 90.91

Chapter 9

9. A company’s 6% coupon rate, semiannual payment, $1,000 par value bond that matures in 30 years sells at a price of $515.16. The company’s federal -plus-state tax rate is 40%.

What is the firm’s after -tax component cost of debt for purposes of calculating the WACC? (Hint: Base your answer on the nominal rate.)

Answer:

N = 60, PV = -515.16, PMT = 30, and FV = 1000, so I = 6% = periodic rate. The simple rate is 6 %(2) = 12% 12% X 0.6= 7.2%

10. The earnings, dividends, and stock price of Shelby Inc. are expected to grow at 7% per year in the future. Shelby’s common stock sells for $23 p er share, its last dividend was $2.00, and the company will pay a dividend of $2.14 at the end of the current year.

a. Using the discounted cash flow approach, what is its cost of equity?

b. If the firm’s beta is 1.6, the risk -free rate is 9%, and the expected return on the market is 13%, then what would be the firm’s c ost of equity based on the CAPM approach?

Answer:

a. k s =

01P D + g = 23$14.2$ + 7% = 9.3% + 7% = 16.3%

b. k s = k RF + (k M - k RF )b

= 9% + (13% - 9%) 1.6 = 9% + (4%) 1.6 = 9% + 6.4% = 15.4%

15. On January 1, the total market value of the Tysseland Company was $60 million. During the year, the company plans to raise and invest $30 million in new projects. The firm’s present market value capital structure, shown below, is considered to be optimal. There is no short-term debt.

New bonds will have an 8% coupon rate, and they will be sold at par. Common stock is currently selling at $30 a share. The stockholders’ required ra te of return is estimated to be 12%, consisting of a dividend yield of 4% and an expected constant growth rate of 8%. (The next expected dividend is $1.20, so the dividend yield is $1.20/$30 = 4 %.) The marginal tax rate is 40%.

a. In order to maintain the present capital structure, how much of the new investment must be financed by common equity?

b. Assuming there is sufficient cash flow for Tysseland to maintain its target capital structure without issuing additional shares of equity, what is its WACC?

c. Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock. Qualitatively speaking, what will happen to the WACC? No numbers are required to answer this question.

Answer:

Debt 30,000,000

Common Equity 30,000,000

Total Capital = 60,000,000

a. In order to maintain the present capital structure, how much of the new investment must be financed by common equity?

Required Investments = $30,000,000

Since the total market value of the firm is $60,000,000

The weight of equity= $30,000,000 / $60,000,000= 0.5

Common equity needed = Total Amount of Investment ×Weight of Equity=

0.5($30,000,000) = $15,000,000.

b. Assuming there is sufficient cash flow for Tysseland to maintain its target capital structure without issuing additional shares of equity, what is its WACC?

Cost of Equity =D/P+g =1.20/30 +0.06= 0.12= 12%

After Tax Cost of Debt = Before Tax Cost of Debt × (1-Tax Rate) = 8 × (1-0.4)= 4.8% WACC = (Weight of Equity × Cost of Equity) + (Weight of Debt × After Tax Cost of Debt) = (0.5 × 12%) + (0.5 × 4.8%) = 8.4%

c. Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock. Qualitatively speaking, what will happen to the WACC? No numbers are required to answer this question.

If new shares are issued, then there is no impact on cost of equity or cost of debt. However, the capital structure changes - the debt value is the same, but the equity value is greater than before. So there is greater weightage to cost of equity than cost of debt. As cost of equity is higher than the current WACC, this will lead to WACC increasing from 8.4% to a higher number