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1. Growth Company's current share price is $20 and is expected to pay a $1 dividend per share next year. After that, the firm's dividends are

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1. Growth Company s current share price is $20 and is expected to pay a $1 dividend per share next year. After that, the firm s dividends are expected to grow at a rate of 4% per year. a. What is an estimate of Growth Company s cost of equity? b. Growth Company also has preferred stock outstanding that pays a $2 per share fixed dividend. If this stock is currently priced at $28, what is Growth Company s cost of preferred stock? c. Growth Company has existing debt issued three years ago with a coupon rate of 6%. The firm just issued new debt at par with a coupon rate of 6.5%. What is Growth company s pre-tax cost of debt? d. Growth Company has 5 million common shares outstanding and 1 million preferred shares outstanding, and its equity has a total book value of $50 million. Its liabilities have a market value of $20 million. If Growth Company s common and preferred shares are priced at $20 and $28, respectively, what is the market value of Growth Company s assets? e. Growth Company faces a 35% tax rate. Given the information in parts (a) to (d), and your answers to those problems, what is Growth Company s WACC? 2. Your company has two divisions: one division sells software and the other division sells computers through a direct sales channel, primarily taking orders over the internet. You have decided that Dell Computer is very similar to your computer division, in terms of both risk and financing. You go online and find the following information: Dell s beta is 1.21, the risk-free rate is 4.5%, its market value of equity is $67 billion, and it has $700 million worth of debt with a yield to maturity of 6%. Your tax rate is 35%, and you use a market risk premium of 5% in your WACC estimates. a. What is an estimate of the WACC for your computer sales division? b. If your overall company WACC is 12% and the computer sales division represents 40% of the value of your firm, what is an estimate of the WACC for your software division? 3. Big Time Inc. is proposing a rights offering. Presently there are 500,000 shares outstanding at $81 each. There will be 60,000 new shares offered at $70 each. a. What is the new market value of the company? b. How many rights are associated with one of the new shares? c. What is the ex-rights price? d. What is the value of a right? 4. Keira Mfg. is considering a rights offer. The company has determined that the ex- rights price would be $52. The current price is $55 per share, and there are 5 million shares outstanding. The rights offer would raise a total of $50 million. a. How many rights are required to get a new share? b. What is the subscription price (the price for a new share)? c. What is the value of a right?
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5. ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all-equity financed with $600,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $300,000 and the interest rate on its debt is 10 percent. Both firms expect EBIT to be $75,000. Ignore taxes. a. Rico owns $30,000 worth of XYZ s stock. What cash flows and rate of return is he expecting? b. Show how Rico could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage (he can borrow at 10%). c. What is the cost of equity for ABC? What is it for XYZ? d. What is the WACC for ABC? For XYZ? What principle have you illustrated? 6. Miles s Manor, an unassuming resort in midstate Pennsylvania, currently has an allequity capital structure. Miles s Manor has an expected income of $10,000 per year forever and a required rate of return to equity of 16%. There are no personal taxes, but Miles s pays corporate taxes at the rate of 35%, and all transactions take place in an otherwise perfect capital market. a. What is Miles s Manor worth? b. What will be the value of the firm if Miles s Manor leverages the firm by borrowing half the value of the unleveraged firm at a rate of 10%? c. Find the return on equity and the WACC at the level of debt found in (b). d. What is the theoretical maximum value for Miles 5. ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all-equity financed with $600,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $300,000 and the interest rate on its debt is 10 percent. Both firms expect EBIT to be $75,000. Ignore taxes. a. Rico owns $30,000 worth of XYZ s stock. What cash flows and rate of return is he expecting? b. Show how Rico could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage (he can borrow at 10%). c. What is the cost of equity for ABC? What is it for XYZ? d. What is the WACC for ABC? For XYZ? What principle have you illustrated? 6. Miles s Manor, an unassuming resort in midstate Pennsylvania, currently has an allequity capital structure. Miles s Manor has an expected income of $10,000 per year forever and a required rate of return to equity of 16%. There are no personal taxes, but Miles s pays corporate taxes at the rate of 35%, and all transactions take place in an otherwise perfect capital market. a. What is Miles s Manor worth? b. What will be the value of the firm if Miles s Manor leverages the firm by borrowing half the value of the unleveraged firm at a rate of 10%? c. Find the return on equity and the WACC at the level of debt found in (b). d. What is the theoretical maximum value for Miles s Manor (if it were all debt
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Solution 1:
a) We have P0 = $20, D1 = 1 and g = 0.04
Using constant growth model,
P0 = D1/ (k – g)
$20 = 1/ (k – 0.04)
k – 0.04 = 0.05
k = 0.05 + 0.04
k = 0.09 or 9%
b) We have D = $2 and P0...

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