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**Unformatted text preview: **Name: ___________________________________ NetID: _______________________ Prof. Q. Ma, HADM 2222 Fall 2009 1/3 HADM 2222 Fall 2009, Prof. Q. Ma Homework assignment #8 [Due 10 a.m. Wednesday, December 2, 2009, Statler 435 drop box] 1. Stock in Country Road Industries has a beta of 1.25. The market risk premium is 7 percent, and T-bills are currently yielding 5 percent. Country Roads most recent dividend was $2.10 per share, and dividends are expected to grow at a 5 percent annual rate indefinitely. If the stock sells for 34 per share, what is your best estimate of the companys cost of equity? Solution : We have the information available to calculate the cost of equity using the CAPM and the dividend growth model. Using the CAPM, we find: R E = .05 + 1.25(.07) = .1375 or 13.75% And using the dividend growth model, the cost of equity is R E = [$2.10(1.05)/$34] + .05 = .1149 or 11.49% Both estimates of the cost of equity seem reasonable. If we remember the historical return on large capitalization stocks, the estimate from the CAPM model is about two percent higher than average, and the estimate from the dividend growth model is about one percent higher than the historical average, so we cannot definitively say one of the estimates is incorrect. Given this, we will use the average of the two, so: R E = (.1375 + .1149)/2 = .1262 or 12.62% 2. Decline, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 12 years to maturity that is quoted at 94 percent of face value. The issue makes semiannual payments and has an embedded cost of 7 percent annually. What is the companys pretax cost of debt? If the tax rate is 35 percent, what is the after tax cost of debt? Solution: The pretax cost of debt is the YTM of the companys bonds, so: P = $940 = $35(PVIFA R%,24 ) + $1,000(PVIF R%,24 ) R = 3.889% YTM = 2 3.889% = 7.78% And the aftertax cost of debt is: R D = .0778(1 .35) = .0506 or 5.06% 3. Mullineaux Corporation has a target capital structure of 50 percent common stock, 5 percent...

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