FINC 322 - Chapter 14 Answers

# FINC 322 - Chapter 14 Answers - CHPATER 14 Basic 1 With the...

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CHPATER 14 Basic 1. With the information given, we can find the cost of equity using the dividend growth model. Using this model, the cost of equity is: R E = [\$2.40(1.055)/\$52] + .055 = .1037 or 10.37% 2. Here we have information to calculate the cost of equity using the CAPM. The cost of equity is: R E = .053 + 1.05(.12 – .053) = .1234 or 12.34% 3. 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 + 0.85(.08) = .1180 or 11.80% And using the dividend growth model, the cost of equity is R E = [\$1.60(1.06)/\$37] + .06 = .1058 or 10.58% 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 = (.1180 + .1058)/2 = .1119 or 11.19% 4. To use the dividend growth model, we first need to find the growth rate in dividends. So, the increase in dividends each year was: g 1 = (\$1.12 – 1.05)/\$1.05 = .0667 or 6.67% g 2 = (\$1.19 – 1.12)/\$1.12 = .0625 or 6.25% g 3 = (\$1.30 – 1.19)/\$1.19 = .0924 or 9.24% g 4 = (\$1.43 – 1.30)/\$1.30 = .1000 or 10.00% So, the average arithmetic growth rate in dividends was: g = (.0667 + .0625 + .0924 + .1000)/4 = .0804 or 8.04% Using this growth rate in the dividend growth model, we find the cost of equity is: R E = [\$1.43(1.0804)/\$45.00] + .0804 = .1147 or 11.47% Calculating the geometric growth rate in dividends, we find: \$1.43 = \$1.05(1 + g) 4 g = .0803 or 8.03%

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The cost of equity using the geometric dividend growth rate is: R E = [\$1.43(1.0803)/\$45.00] + .0803 = .1146 or 11.46% 5. The cost of preferred stock is the dividend payment divided by the price, so: R P = \$6/\$96 = .0625 or 6.25% 6. The pretax cost of debt is the YTM of the company’s bonds, so: P 0 = \$1,070 = \$35(PVIFA R%,30 ) + \$1,000(PVIF R%,30 ) R = 3.137% YTM = 2 × 3.137% = 6.27% And the aftertax cost of debt is: R D = .0627(1 – .35) = .0408 or 4.08% 7. a. The pretax cost of debt is the YTM of the company’s bonds, so: P 0 = \$950 = \$40(PVIFA R%,46 ) + \$1,000(PVIF R%,46 ) R = 4.249% YTM = 2 × 4.249% = 8.50% b. The aftertax cost of debt is: R D = .0850(1 – .35) = .0552 or 5.52% c. The after-tax rate is more relevant because that is the actual cost to the company. 8. The book value of debt is the total par value of all outstanding debt, so: BV D = \$80,000,000 + 35,000,000 = \$115,000,000 To find the market value of debt, we find the price of the bonds and multiply by the number of bonds. Alternatively, we can multiply the price quote of the bond times the par value of the bonds. Doing so, we find: MV D = .95(\$80,000,000) + .61(\$35,000,000) MV D = \$76,000,000 + 21,350,000 MV D = \$97,350,000 The YTM of the zero coupon bonds is: P Z = \$610 = \$1,000(PVIF R%,14 ) R = 3.594% YTM = 2 × 3.594% = 7.19% So, the aftertax cost of the zero coupon bonds is:
R Z = .0719(1 – .35) = .0467 or 4.67% The aftertax cost of debt for the company is the weighted average of the aftertax cost of debt for all outstanding bond issues. We need to use the market value weights of the bonds. The

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