Two years ago Clark Company issued a 10-year, 12% annual coupon bond at its par
ID: 2726595 • 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. lf Clark Company decides to issue new stock with flotation cost of 2%, what is the cost of new common stock?Explanation / Answer
Solution
Required Rate of Return (CAPM approach) = Risk Free Return + Beta x (Market Return - Risk Free return)
Risk Free Return = T-bill return = 5.5%
Required Rate of Return (CAPM approach) = 5.5% + 1.6 (13% - 5.5%) = 5.5% + 12% = 17.50%
Required Rate of Return (DCF Approach) = Next Year Expected Dividend / Current Market Price of Stock + Growth Rate
Next Year Expected Dividend (D1) = Dividend Just paid x (1 + Growth Rate) = $3 x (1 + 0.07) = $3.21
Current Market Price of Stock = $23
Required Rate of Return (DCF Approach) = $3.21 / $23 + 0.07
= 0.13956 + 0.07
= 0.20956 or 20.96%
Required Rate of Return (Bond Yield + Risk Premium Approach) = T-bonds Yield + Risk Premium = 10% + 3.5% = 13.5%
Cost of New Common Stock = Expected Dividend of Next Year / (Current Market Price - Flotation Cost) + Growth Rate
= $3.21 / ($23 - 23*2%) + 0.07
= $3.21 / $22.54 + 0.07
= 0.1424 + 0.07
= 0.2124 or 21.24%
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