Answers to Chapter 7 Stocks, Stock Valuation, and stock market Equilibrium Answers to Chapter 9 The Cost of Captial 7-2

Constant Growth Valuation

Boehm Incorporated is expected to pay a $1.50 per share dividend at the end of the year.(i.e D1=$1.50) The dividend is expected to grow at a constant rate of 7% a year. The required rate of return on the stock is 15%. What is the value per share of Boehms stock? Using the formula from our book, we take 1.50 multiply it by 1 + the 7% growth rate and get 1.5 (1.07) = 1.605 From part two of the formula we take what we just got and divide by the required rate of return minus the growth rate: (1.50)(1.07) /(.15 - .07) = 1.605 / .08 = 20.0625 or $20.63

7-4 Preferred Stock Valuation

Nicks Enchiladas Incorporated has preferred stock outstanding that pays a dividend of $5 at the end of each year. The preferred sells for $50 a share. What is the stocks required rate of return? $5/$50 = 10%

7-5 Non-constant Growth Valuation

A company currently pays a dividend of $2 per share, Do =$2. It is estimated that the companys dividend will grow at a rate of 20% per year for the next 2 years, then the dividend will grow at a constant rate of 7% thereafter. The companys stock has a beta equal to 1.2, the risk-free rate is 7.5%, and the market risk premium is 4%. What is your estimate of the stocks current price? Stock Return D1 D2 D3 P2 Stock current price 16.50% 2.40 2.88 3.08 32.44 Discounted 2.06 2.12 23.90 28.08

9-2 After-Tax Cost of Debt

LL Incorporated's currently outstanding 11% coupon bonds have a yield to maturity of 8%. LL believes it could issue at par new bonds that would provide a similar yield to maturity. If its marginal tax rate is 35%, what is LL's after-tax cost of debt? After tax cost of debt = rd(1-T) Bonds yield 8% Tax 35% After tax cost of debt = 5.20% rd(1 - T) = 0.08(0.65) = 5.2%.

9-4 Cost of Preferred Stock with Flottion Costs

Burnwood Tech plans to issue some $60 par preferred stock with a 6% dividend. A similar stock is selling on the market for $70.00. Burnwood must pay flotation costs, of 5% of the issue price. What is the cost of the preferred stock?

rps =

$60 (0.06 ) $3.60 = = 5.41%. $70 .00 (1 0.05 ) $66.50

9-5 Cost of Equity - DCF

Summerdahl Resorts common stock is currently trading at $36 a share. The stock is expected to pay a dividend of $3.00 a share at the end of the year (D1 - $3.00), and the dividend is expected to grow at a constant rate of 5% a year. What is its cost of common equity? The formula for calculating cost of equity is Ke = (D1 / P0) + g Where D1 = $3 P0 = $36 g = 5% Ke = ($3 / $36) + 0.05 = 0.133 or 13.3% Therefore, the cost of equity is 13.3% The Cost of Equity is 13.3%

9-6 Cost of Equity - CAPM

Booher Book Stores has a beta of 0.8. The yield on a 3-month T-bill is 4% and the yield on a 10-year Tbond is 6%. The market risk premium is 5.5%, and the return on an average stock in the market last year was 15%. What is the estimated cost of common equity using the CAPM? Stock Beta = 0.8 Yield on a 3 month T-bill is 4% Risk-free Rate (Rf) = 4% Yield on a 10 year T-bond = 6% Market Risk-premium (MRP) = 5.5% Rate of Return on a Average Stock in the market last year was = 15% Calculating Estimated Cost of Common Equity using CAPM: According to CAPM: RE = Rf + * MRP RE = 4% + 0.8 * 5.5% RE = 0.04 + (0.8 * 0.055) RE = 0.04 + 0.044 RE = 0.084 (or) 8.4% Estimated Cost of Common Equity ( RE ) = 8.4%

9-7 WACC
Shi Importers balance sheet shows $300 million in debt, $50 million in preferred stock, and $250 million in total common equity. Shis tax rate is 40%, rd = 6%, rps = 5.8%, and rs = 12%. If Shi has a target capital structure of 30% debt, 5% preferred stock, and 65% common stock, what is its WACC?

WACC =rd(1-tax rate) X weight of debt + rsp X weight of preferred stock + rs X weight of common stock WACC = 3.6% X 30% + 5.8% X 5% + 12% X 65% WACC = 1.08 + 0.29 + 7.8 WACC = 9.17 Hence the WACC is 9.17%