Unformatted text preview: hich is the level perpetuity equation, so the required return on the company’s preferred stock is: R P = D1 / P 0 RP = $4 / $78 RP = .0513 or 5.13% Notice that the required return in the preferred stock is lower than the required on the bonds. This result is not consistent with the risk levels of the two instruments, but is a common occurrence. There is a practical reason for this: Assume Company A owns stock in Company B. The tax code allows Company A to exclude at least 70 percent of the dividends received from Company B, meaning Company A does not pay taxes on this amount. In practice, much of the outstanding preferred stock is owned by other companies, who are willing to take the lower return since it is effectively tax exempt. Now we have all of the components to calculate the WACC. The WACC is: WACC = .0332(47.92/200.02) + .0346(27.3/200.02) + .1170(117/200.02) + .0513(7.8/200.02) WACC = .0831 or 8.31% 20. The total cost of the equipment including flotation costs was: Total costs = $15,000,000 + 850,000 = $15,850,000 Using the equation to calculate the total cost including flotation costs, we get: Amount raised(1 – fT) = Amount needed after flotation costs $15,850,000(1 – fT) = $15,000,000 fT = .0536 or 5.36% Now, we know the weighted average flotation cost. The equation to calculate the percentage flotation costs is: fT = .0536 = .07(E/V) + .03(D/V) We can solve this equation to find the debtequity ratio as follows: .0536(V/E) = .07 + .03(D/E) We must recognize that the V/E term is the equity multiplier, which is (1 + D/E), so: .0536(D/E + 1) = .07 + .03(D/E) D/E = 0.6929 21. a. Using the dividend discount model, the cost of equity is: 317 b. RE = [(0.80)(1.05)/$61] + .05 RE = .0638 or 6.38% Using the CAPM, the cost of equity is: RE = .055 + 1.50(.1200 – .0550) RE = .1525 or 15.25% c. When using the dividend growth model or the CAPM, you must remember that both are estimates for the cost of equity. Additionally, and perhaps more importantly, each method of estimating the cost of equity depends upon different assumptions. Challenge 22. We can use the debtequity ratio to calculate the weights of equity and debt. The debt of the company has a weight for longterm debt and a weight for accounts payable. We can use the weight given for accounts payable to calculate the weight of accounts payable and the weight of longterm debt. The weight of each will be: Accounts payable weight = .20/1.20 = .17 Longterm debt weight = 1/1.20 = .83 Since the accounts payable has the same cost as the overall WACC, we can write the equation for the WACC as: WACC = (1/1.7)(.14) + (0.7/1.7)[(.20/1.2)WACC + (1/1.2)(.08)(1 – .35)] Solving for WACC, we find: WACC = .0824 + .4118[(.20/1.2)WACC + .0433] WACC = .0824 + (.0686)WACC + .0178 (.9314)WACC = .1002 WACC = .1076 or 10.76% We will use basically the same equation to calculate the weighted average flotation cost, except we will use the flotation cost for each form of financing. Doing so, we get: Flotation costs = (1/1.7)(.08) + (0.7/1.7)[(.20/1.2)(0) + (1/1.2)(.04)] = .0608 or 6.08% The total amount we need to raise to fund the new equipment will be: Amount raised cost = $45,000,000/(1 – .0608) Amount raised = $47,912,317 Since the cash flows go to perpetuity, we can calculate the present value using the equation for the PV of a perpetuity. The NPV is: NPV = –$47,912,317 + ($6,200,000/.1076) NPV = $9,719,777 318 23. We can use the debtequity ratio to calculate the weights of equity and debt. The weight of debt in the capital structure is: wD = 1.20 / 2.20 = .5455 or 54.55% And the weight of equity is: wE = 1 – .5455 = .4545 or 45.45% Now we can calculate the weighted average flotation costs for the various percentages of internally raised equity. To find the portion of equity flotation costs, we can multiply the equity costs by the percentage of equity raised externally, which is one minus the percentage raised internally. So, if the company raises all equity externally, the flotation costs are: fT = (0.4545)(.08)(1 – 0) + (0.5455)(.035) fT = .0555 or 5.55% The initial cash outflow for the project needs to be adjusted for the flotation costs. To account for the flotation costs: Amount raised(1 – .0555) = $145,000,000 Amount raised = $145,000,000/(1 – .0555) Amount raised = $153,512,993 If the company uses 60 percent internally generated equity, the flotation cost is: fT = (0.4545)(.08)(1 – 0.60) + (0.5455)(.035) fT = .0336 or 3.36% And the initial cash flow will be: Amount raised(1 – .0336) = $145,000,000 Amount raised = $145,000,000/(1 – .0336) Amount raised = $150,047,037 If the company uses 100 percent internally generated equity, the flotation cost is: fT = (0.4545)(.08)(1 – 1) + (0.5455)(.035) fT = .0191 or 1.91% And the initial cash flow will be: Amount raised(1 – .0191) = $145,000,000 Amount raised = $145,000,000/(1 – .0191) Amount raised = $147,822,057 319 24. The $4 million cost of the land 3 years ago is a sunk cost and irrelevant; the $5.1 million appraised value of the land is an opportunity cost and is rele...
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This note was uploaded on 07/10/2010 for the course FIN 6301 taught by Professor Eshmalwi during the Spring '10 term at University of TexasTyler.
 Spring '10
 eshmalwi
 Finance, Corporate Finance

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