Corporate Finance

Assignment

Cost of Capital

1. Calculating Cost of Equity The Wind Rider Co. just issued a dividend of $2.10 per share on
its common stock. The company is expected to maintain a constant 7 percent growth rate in its
dividends indefinitely. If the stock sells for $40 a share, what is the company’s cost of equity?

2. Calculating Cost of Equity The Tubby Ball Corporation’s common stock has a beta of 1.15.
If the risk-free rate is 5 percent and the expected return on the market is 12 percent, what is
Tubby Ball’s cost of equity capital?

3. Calculating Cost of Equity Stock in Parrot head Industries has a beta of 1.10.The market risk
premium is 8 percent, and T-bills are currently yielding 5.5 percent. Parrot head’s most recent
dividend was $2.20 per share, and dividends are expected to grow at a 5 percent annual rate
indefinitely. If the stock sells for $32per share, what is your best estimate of Parrot head’s cost of
equity?

4. Estimating the DCF Growth Rate Suppose Massey Ltd. just issued a dividend of $.68 per
share on its common stock. The company paid dividends of $.40, $.45, $.52, and $.60 per share
in the last four years. If the stock currently sells for $12, what is your best estimate of the
company’s cost of equity capital?

5. Calculating Cost of Preferred Stock Holdup Bank has an issue of preferred stock with a $5
stated dividend that just sold for $92 per share. What is the bank’s cost of preferred stock?

6. Calculating Cost of Debt Legend, Inc., is trying to determine its cost of debt. The firm has a
debt issue outstanding with 12 years to maturity that is quoted at 107 percent of face value. The
issue makes semiannual payments and has an embedded cost of 10 percent annually. What is
Legend’s pretax cost of debt? If the tax rate is 35 percent, what is the after tax cost of debt?

7. Calculating Cost of Debt Jiminy’s Cricket Farm issued a 30-year, 9 percent semiannual bond
8 years ago. The bond currently sells for 105 percent of its face value. The company’s tax rate is
35 percent.
a. What is the pretax cost of debt?

b. What is the after tax cost of debt?

c. Which is more relevant, the pretax or the after tax cost of debt? Why?

8. Calculating WACC Mullineaux Corporation has a target capital structure of 50 percent

common stock, 5 percent preferred stock, and 45 percent debt. Its cost of equity is 18 percent, the
cost of preferred stock is 6.5 percent, and the cost of debt is 8 percent. The relevant tax rate is 35
percent.

a. What is Mullineaux’s WACC?

b. The company president has approached you about Mullineaux’s capital structure. He wants to
know why the company doesn’t use more preferred stock financing, since it costs less than debt.
What would you tell the president?

9. Taxes and WACC Modigliani Manufacturing has a target debt-equity ratio of.75. Its cost of
equity is 18 percent and its cost of debt is 10 percent. If the tax rate is 35 percent, what is
Modigliani’s WACC?

10.WACC Sniffles, Inc., has a target debt-equity ratio of .90. Its WACC is 13 percent, and the
tax rate is 35 percent.

a. If Sniffles’ cost of equity is 18 percent, what is its pretax cost of debt?

b. If instead you know that the after tax cost of debt is 7.5 percent, what is the cost of equity?

Risk and Return

Question 1

The following information about a two stock portfolio is available:

  Stock A Stock B
Amount 20,000 30,000
Expected Returns 12% 20%
Standard Deviation 20% 30%
Correlation 0.25
Question 2

Suppose you have invested only in two stocks, A and B. You expect that returns on the stocks
depend on the following three states of economy, which are equally likely to happen.

1. Calculate the expected return of each stock.

2. Calculate the standard deviation of returns of each stock.

3. Calculate the covariance and correlation between the two stocks.

Question 3

Suppose the current risk-free is 7.6 percent. Potpourri Inc. stock has a beta of 1.7 and an
expected return of 16.7 percent. (Assume the CAPM is true)

a. What is the risk premium on the market?

b. Magnolia Industries stock has a beta of 1.8. What is the expected return on the Magnolia
stock?

c. Suppose you have invested $100,000 in a portfolio of Potpourri and Magnolia, and the beta of
the portfolio is 1.77. How much did you invest in each stock? what is the expected return on the
portfolio?

4. Using CAPM A stock has a beta of 1.5, the expected return on the market is14 percent, and
the risk-free rate is 5 percent. What must the expected return on this stock be?

5. Using CAPM A stock has an expected return of 13 percent, the risk-free rate is 5 percent, and
the market risk premium is 7 percent. What must the beta of this stock be?

6. Using CAPM A stock has an expected return of 10 percent, its beta is .9, and the risk-free rate
is 6 percent. What must the expected return on the market be?
7. Using CAPM A stock has an expected return of 14 percent, a beta of 1.6, and the expected
return on the market is 11 percent. What must the risk-free rate be?

8. A four-stock portfolio is made up as follows. Stock Current Value Beta A $4,500 .8 B 2,900 .6
C 6,800 1.3 D 1,200 1.8 Calculate the portfolio’s beta.

9. The Aldridge Co. is expected to grow at 6% into the indefinite future. Its latest annual
dividend was $2.50. Treasury bills currently earn 7% and the S&P 500 yields 11%.

a. What price should Aldridge shares command in the market if its beta is 1.3?

b. Evaluate the sensitivity of Aldridge’s price to changes in expected growth and risk by
recalculating the price while varying the growth rate between 5% and 7% (increments of 1%)
and varying beta between 1.2 and 1.4 (increments of .1).

10. Consider the following simplified APT model:

Calculate the expected return for the following stocks. Assume rf = 5%.
11. Look again at Problem 19. Consider a portfolio with equal investments in stocks P, P2, and
P3.

a. What are the factor risk exposures for the portfolio?

b. What is the portfolio’s expected return?