Ch 09 Mini Case - 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17...

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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% (1-Tax 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% (1-Tax rate) x 60% x 10% 6.0% A-T Risk Premium on Prefer ed 1.92% The CAPM Ap roach PROBLEM Risk-fre 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 = (1-Payout 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 bond-yield-plus-risk-premium method? THE BOND-YIELD-PLUS-RISK-PREMIUM 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 Risk-fre rate 7% Market risk premium 6.0% 17.2% Beta 1.7 Target Debt Ratio 10% 12% Tax Rate 40% WACC = x (1-T) + 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 = (1-F) 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.

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