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Ch 09 Mini Case
5/23/20 3
Chapter 9. Mini Case
Situation
(1)
The firm's tax rate is 40%
To structure the task somewhat, Jones has asked you to answer the fol owing questions.
b.
What is the market interest rate on Har y Davis' debt and its component cost of debt?
0
1
2
30
N
30
PV
1,153.72
PMT
60
FV
10 0
10%
PROBLEM
10%
Tax rate
40%
(1Tax rate)
x
60%
x
10%
6.0%
c.
(1.) What is the firm's cost of prefer ed stock?
PROBLEM
Pref. Dividen
$10.0
Pref. Price
$1 3.10
Flotation cos
$2.0
Pref. Dividend
÷
(Pref. Price

Flotation Costs)
$10.0
÷
$1 3.10
$2.0
9.0%
Example
9%
10%
T
40%

x
(1.7) *T
9%

9%
x
0.12
7.92%
(1Tax rate)
x
60%
x
10%
6.0%
AT Risk Premium on Prefer ed
1.92%
The CAPM Ap roach
PROBLEM
Riskfre rate
7%
Expected market return
13%
Beta
1.2
+
7.0%
+
6.0%
1.2
7.0%
+
7.2%
14.2%
THE DISCOUNTED CASH FLOW APPROACH
e.
(1.) What is the estimated cost of equity using the discounted cash flow (DCF) ap roach?
The simplest DCF model as umes that growth is expected to remain constant, and in this case:
rs = D1/P0 + g.
PROBLEM
$50.0
$4.40
g =
5%
÷
+
g
$4.40
÷
$50.0
+
5%
13.8%
2. Retention Growth Model
PROBLEM
Find g
Payout rate =
65%
ROE =
15.0 %
g = (1Payout rate)(ROE)
g =
35%
15.0 %
g =
5.25%
(3.)
Could the DCF method be ap lied if the growth rate was not constant?
How?
APPLICATION OF THE DISCOUNTED CASH FLOW APPROACH WHEN GROWTH IS NOT CONSTANT
PROBLEM
Step 1:
Year
0
1
2
3
4
5
Growth
1 %
10%
9%
8%
7%
Dividend
2.16
2.40
2.64
2.87
3.10
3.32
Step 2:
Price at Year 4 =
$42.20
Step 3:
Calculated Cur ent Price
$32.0
Step 4:
14.9%
f.
What is the cost of equity based on the bondyieldplusriskpremium method?
THE BONDYIELDPLUSRISKPREMIUM APPROACH
Equity RP =
4%
Bond yield =
10.0%
(Equity RP)(Bond yield)
4%
10.0%
14.0%
THE COST OF EQUITY ESTIMATE
It is common to use several methods to estimate the cost of equity, and then find the average of these methods.
Method Cost of Equity
14.2%
13.8%
14.0%
14.0%
THE WEIGHTED AVERAGE COST OF CAPITAL
PROBLEM
h.
What is Har y Davis' weighted average cost of capital (WACC)?
30%
6.0%
10%
9.0%
WACC =
1 .10%
60%
14.0%
Their capital structure is 10 percent debt and 90 percent common equity
Their cost of debt is typical y 12 percent.
The beta is 1.7.
Given this information, what would your estimate be for the division’s cost of capital?
ADJUSTING THE COST OF CAPITAL FOR RISK
PROBLEM
Riskfre rate
7%
Market risk premium
6.0%
17.2%
Beta
1.7
Target Debt Ratio
10%
12%
Tax Rate
40%
WACC =
x
(1T)
+
WACC =
1.2%
x
60%
+
15.5%
WACC =
16.2%
check this
Division WACC
16.2%
Company WACC
1 .10%
ADJUSTING THE COST OF CAPITAL FOR FLOTATION COSTS
PROBLEM: Flotation Costs and the Cost of New Equity
$50.0
$4.40
g =
5%
÷
+
g
$4.40
÷
$50.0
+
5%
13.8%
Flotation percentage cost (F) =
15%
Stock price =
$50.0
Net proce ds after flotation costs =
(1F)
Net proce ds after flotation costs =
$50.0
85%
Net proce ds after flotation costs =
$42.50
Net proce ds after flotation costs =
$42.50
$4.40
g =
5%
÷
Net Proce d
+
g
$4.40
÷
$42.50
+
5%
15.4%
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This note was uploaded on 12/01/2011 for the course ACCOUNTING 151 taught by Professor Larson during the Spring '11 term at Everest University.
 Spring '11
 larson

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