Two years ago Clark Company issued a 10-year, 12% annual coupon bond at its par
ID: 2724677 • Letter: T
Question
Two years ago Clark Company issued a 10-year, 12% annual coupon bond at its par value of $1,000. Currently, the bond can be called in 4 years at a price of $1,060 and it sells for $1,100. The company has a risk premium of 3.5%, a beta of 1.6, and the average return on the market is 13%. Clark Company just paid a dividend of $3.00 and the dividends are expected to grow at 7% per year. If you read in the wall street journal that 30- day T-bills are currently yielding 5.5% and 30-year T-Bonds are yielding 10%, what is the required rate of return on this stock if the stock is selling for $23.00 per share? Use the average of the 3 estimates approach. (HINT: to use CAPM approach you need to identify the risk free rate, to use DCF approach you need 1, to use Bond yield+ risk premium approach, you need the bond yield.)
If Clark Company decides to issue new stock with flotation cost of 2%, what is the cost of new common stock?
Explanation / Answer
Required rate of return as per CAPM: E(Rj) =Rf + Beta*(Rm-Rf)
Risk free rate = 5.5% (Yield of 30-days T-bills)
Market return = 13%
Beta = 1.6
Required Return = 5.5% + 1.6*(13% - 5.5%) = 17.50%
Required rate of return as per DCF: P0 = D0 / (Ke-G)
P0 = $23
D0 = $3
Ke = required rate of return
$23 = $3/(Ke – 0.07)
Ke = 0.2004 or 20.04%
Required rate of return as per bond yield+ risk premium approach:
= {$120 + [($1,060 - $1,100)/4]} / {[$1,060+$1,100]/2} = 10.19%
Required rate of return = 10.19% + 3.5% =13.69%
Average of three = (17.50% + 20.04% + 13.69%)/3 = 17.08%
Cost of new stock = 17.08% + 2% = 19.08%
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