Valley Flights, Inc. has a capital structure made up of 40% debt and 60% equity

Question

Valley Flights, Inc. has a capital structure made up of 40% debt and 60% equity and a tax rate of 30%. A new issue of $1,000 par bonds maturing in 20 years can be issued with a coupon of 9% at a price of $1,098.18 with no flotation costs. The firm has no internal equity available for investment at this time, but can issue new common stock at a price of $45. The next expected dividend on the stock is $2.70. The dividend for the firm is expected to grow at a constant annual rate of 5% per year indefinitely. Flotation costs on new equity will be $7.00 per share. The company has the following independent investment projects available:

Project Initial Outlay IRR
1 $100,000 10%
2 $ 10,000 8.5%
3 $ 50,000 12.5%

Which of the above projects should the company take on?

Project 1&2

Project 3 only

Projects 1 & 3

Projects 1, 2, and 3

The risk free rate of return is 2.5% and the market risk premium is 8%. Rogue Transport has a beta of 2.2 and a standard deviation of returns of 28%. Rogue Transport's marginal tax rate is 35%. Analysts expect Rogue Transport's dividends to grow by 6% per year for the foreseeable future. Using the capital asset pricing model, what is Rogue Transport's cost of retained earnings?

20.1%

19.6%

16.4%

17.7%

Explanation / Answer

Answer-2:

Cost of retained earnings = Risk Free rate + Beta * Marker risk premium

= 2.5 + 2.2 *8

= 20.1%

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