Group 1 - Exercise 5

Answer:

Summary:
Earning per share (EPS) = $3.2
Price of common stock (𝑃0) = $55

Last’s year dividend of common stock (𝐷0) = $2.1

Flotation cost (f) = 10%

Constant growth rate (g) = 10%

Dividend of preferred stock (𝐷𝑃) = $3.3

Price of preferred stock (𝑃𝑃) = $31

Interest rate of long-term debt (𝑟𝑑) = 10%

Tax rate (T) = 34%

Market risk premium (𝑅𝑀 − 𝑅𝐹) = 5%

Risk-free rate = 6%
Beta = 1.316

a) Cost of each capital component

+ The after-tax cost of debt = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 * (1 − 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒) = 𝑟𝑑 * (1 − 𝑇)

= 10% * (1 − 34%) = 0.066 = 6.6%

𝐷𝑝 $3.3
+ Cost of preferred stock (𝑟𝑝) = 𝑃𝑝
= $31
= 0. 106 = 10.6%

+ Cost of equity from retained earnings (𝑟𝑠) (DCF method)

𝐷1 𝐷0 * (1+𝑔) $2.1 * (1+10%)
= 𝑃0
+𝑔 = 𝑃0
+ 𝑔 = $55
+ 10% = 0. 142

= 14.2%

+ Cost of newly issued common stock (𝑟𝑒) (DCF method)

𝐷1 𝐷0 * (1+𝑔)
= 𝑃0 * (1−𝑓)
+ 𝑔 = 𝑃0 * (1−𝑓)
+ 𝑔
 2.1 * (1+10%)
= 55 * (1−10%)
+ 10% = 0. 1467 = 14.67%

b) Cost of common equity using from retained earnings (CAPM method)

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑅𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + 𝐵𝑒𝑡𝑎 × 𝑀𝑎𝑟𝑘𝑒𝑡 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚

⇔ 𝑟𝑠 = 𝑟𝑓 + β * (𝑟𝑚 − 𝑟𝑓)

⇒ 𝑟𝑠 = 6% + 1. 316 × 5% = 0. 1258 𝑜𝑟 12. 58%

c) What is the cost of new common stock based on the CAPM?

There is no direct way to calculate it based on the CAPM, however, we can adjust the
CAPM value of 𝑟𝑠 by the differential based on dividend calculations.

- The difference between 𝑟𝑒 and 𝑟𝑠:

𝐷𝑖𝑓𝑓 = 𝑟𝑒 − 𝑟𝑠 = 14.67% - 14.2% = 0.47%

→ Cost of new common stock:

𝑟𝑒 = 𝑟𝑠 + 𝐷𝑖𝑓𝑓 = 12.58% + 0.47% = 13.05%

d) Calculating the firm’s WACC if

(1) It uses only retained earnings for equity

Market Value Wi (%) Ri (%) Wi*Ri (%)

Equity (retained $1,350 48.21 14.2 6.84582

earnings)

Preferred stock $250 8.93 10.6 0.94658

Long-term debt $1,200 42.86 6.6 2.82876

Total Value = $2,800

𝑅𝑊𝐴𝐶𝐶 = ∑ 𝑊𝑖𝑅𝑖 =

10.62116
 𝑤𝑠 = $1, 350 : $2, 800 * 100 = 48. 21%

𝑤𝑝 = $250 : $2, 800 * 100 = 8. 93%

𝑤𝑑 = $1, 200 : $2, 800 * 100 = 42. 86%

(2) It expands so rapidly that it must issue new common stock?

Market Value Wi (%) Ri (%) Wi*Ri (%)

(New) Common stock $1,300 47.27 14.67 6.201009

Preferred stock $250 9.09 10.6 0.96354

Long-term debt $1,200 43.64 6.6 2.88024

Total Value = $2,750

𝑅𝑊𝐴𝐶𝐶 = ∑ 𝑊𝑖𝑅𝑖 =

10.044789

𝑤𝑒 = $1, 300 : $2, 750 * 100 = 47. 27%

𝑤𝑝 = $250 : $2, 750 * 100 = 9. 09%

𝑤𝑑 = $1, 200 : $2, 750 * 100 = 43. 64%

Evidence: https://youtu.be/rosU1wqjqeM